This week Dominic Picarda looks at countertrend trading.
Is the trend your friend?
‘The trend is your friend’ is the first rule of trading. It is always much easier to make money when you are buying into an uptrend or selling into a downtrend.Trading with the trend is like paddling downstream – you’ve got the natural current of the market in your favour. Going against the current is hard work and is more likely to see you sink.
That said, though, you can still make profits by going against the flow, but you need to be particularly careful when doing so.
In the accompanying chart, you can clearly see the FTSE 100 is in a strong uptrend. The most obvious strategy here, therefore, would be to “buy on dips.”
However, there are also a number of occasions where the index has dropped sharply by more than 120 points over as little as a day or so. Such moves can be worth catching, but you need to be pretty nimble.
Only when the time is right
To spot a situation where a pullback is imminent, look for signs that the main trend is overstretched. One sign of this is if the price is near or exceeds one of its Bollinger bands (the blue lines on either side of the price).Also, your preferred momentum oscillator should be in overstretched territory, but rolling over in the direction you intend to trade. A price-reversal pattern should then be the trigger for your trade.
On the occasions that have been ringed on the chart, all these features are in evidence. Momentum is overbought, with relative strength index (RSI) above 73 per cent on the first three occasions.
On the fourth occasion, a new peak in the price has not been accompanied by a new high in the RSI, which is a warning of potential reversal.
Because you are trading against the trend, you need to be especially rigorous about placing stop-losses in case things turn suddenly against you. And, you need to be equally quick about taking profits. A limit order to get you out automatically is a good idea here. (Stop losses are not guaranteed).
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