What is a Countertrend Strategy
A countertrend strategy is a trading method that attempts to make small gains by trading against the current trend. Traders also refer to the practice as "countertrend trading." Contrarian traders employ countertrend trading strategies. They attempt to purchase shares when a security’s price is low and sell when it’s high. Traders who use this strategy realize smaller gains and are prepared to forego the bulk of a trending move. A countertrend strategy ignores the popular investment philosophy "the trend is your friend."
BREAKING DOWN Countertrend Strategy
Countertrend strategies use momentum indicators, reversal patterns and trading ranges to determine the best areas to execute trades. Traders who use this strategy should always be mindful that a security can resume its trend at any moment and should therefore use risk management techniques, such as stop-loss orders, to limit possible losses.
Constructing a Countertrend Strategy
Traders can use momentum indicators, such as the relative strength index (RSI), in conjunction with price support and resistance areas to locate high probability turning points. For example, a countertrend trader may buy a security if it finds support at a 52-week low and the RSI gives an oversold reading below 30. Conversely, the trader could open a short position if the security’s price reaches a resistance area and the RSI moves above 70.
To add further confirmation, the trader may wait for a bullish or bearish candlestick pattern before entering the trade. The countertrend range should be wide enough the have a profit target that’s at least twice as wide as the stop loss. For instance, if a trader is using a $5 stop loss, the profit target should be at least $10. (For more, see: Combining Trend and Countertrend Indicators.)
Benefits of Using a Countertrend Strategy
More Trading Opportunities: When the price of a security oscillates within a trading range, it presents many opportunities to buy at support and sell short at resistance. An investor may have to sit on his hands for an extended period if he only trades pullbacks in a trending market.
Shallower Drawdowns: Countertrend strategies typically have shallower drawdowns compared to trend-following strategies, as traders take smaller profits more regularly. Although a trend strategy may produce more substantial gains overall, the trader may get stopped out numerous times before capturing a large move.
Limitations of Using a Countertrend Strategy
Commissions: Acting on more trading opportunities results in paying more commission charges. Traders who use a countertrend strategy and anticipate making a significant number of monthly transactions should consider using a per share commission structure. This means the broker charges a flat fee per share as opposed to a per trade fee. Traders then only pay a commission for the number of shares they trade, which allows them to scale in and out of positions more frugally.
Time intensive: Countertrend moves don’t last as long as trending moves; therefore, traders need to frequently monitor the markets to find the best entry and exit points for their trades. Traders can automate their countertrend strategies to overcome this limitation. (See also: Automated Trading Systems: The Pros and Cons.)