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Using countertrend trading in bearish trading

Using Countertrend Trading in Bearish Trading

Bearish countertrend trading involves selling short securities when prices are increasing with the prevailing trend, in anticipation of a reversal to the downside. Of course, this is an aggressive strategy because the trader is trying to pick the moment a rising stock will cease to do so. The ultimate goal of bearish countertrend trading is to sell short as close to a price top as possible, increasing the trader’s return. Once in a short position, the trader may similarly exit their profitable trades by attempting to “buy into weakness” as the stock moves lower.

The primary purpose for using a countertrend catalyst is the potential for larger profit by attempting to sell short closer to the top of a given price advance. Conversely, a trend following trader would wait for the current advance to end and a new downtrend to clearly develop before acting. By their nature, countertrend traders are aggressive and willing to take on substantial risk. Let’s look at some considerations of the Bearish Countertrend approach.

Timeframe considerations

A countertrend trader can choose to trade in any timeframe. However, many tend to focus on a shorter-term timeframe for two important reasons:

  1. Long-term trends take a long time to change–picking the exact moment when a trend reverses is difficult and unlikely
  2. Countertrend means increased risk. This trader wants to know as quickly as possible whether they’re right or wrong. Acting quickly to limit losses is imperative.

In general, countertrend trading requires strict discipline and risk management. Entering trades with well-established exit strategies will help this trader to capitalize when they’re right but keep downside limited to a comfortable level.

Using countertrend tools as a catalyst to enter and exit bearish trades

Please note that deeper examination of the indicators discussed below is strongly encouraged before using them in your strategies. Further, the review is a summary of these indicators and not comprehensive.

Countertrend traders will often use one or a group of, ‘overbought and oversold’ indicators in order to identify potential countertrend opportunities. These opportunities are perceived to have merit because stock price action can have a rubber-band appearance. That is, an extended move into overbought or oversold territory can result in a ‘snap back’ at some point, creating an opportunity for the aggressive trader. Of course, this rubber band action can fail to materialize, leaving the buyer at risk for further buying and selling and principal risk.  

Countertrend catalyst: Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a technical indicator that attempts to identify the balance between buying and selling pressure for a given security over a specific period of time. The indicator has values ranging from 0 to 100 with 50 being considered neutral. The closer RSI moves towards 0, the more selling pressure is exceeding buying pressure and the more “oversold” the security is considered to be. The closer RSI moves towards 100 the greater buying pressure is exceeding selling pressure and the more “overbought” the security is considered to be.

The key determinant of how much and how quickly RSI will fluctuate is the number of days used in the calculation. The industry standard for RSI is to use 14 days to calculation. However, many countertrend traders will utilize a smaller value in order to highlight shorter-term overbought/oversold situations.

For example, if we look at XYZ using a 4-day RSI, a bearish countertrend trader might consider selling short the security when the 4-day RSI rises to an overbought level (70% or higher), and then falls below it , generating a signal that bearish sentiment may be gaining momentum. Then, they might consider buying it back when the 4-day RSI falls to an oversold level (30% or lower), and then rises back above it, generating a signal that bullish sentiment may be gaining momentum.

Source: StreetSmart Edge®

Countertrend catalyst example: Bollinger Bands®

Bollinger Bands are a technical analysis indicator that helps to identify situations where a security’s price is perceived to have extended too far in one direction and may be due for a reversal. By default in Schwab platforms, the Bollinger Bands use the 20-period simple moving average as the center ‘base line’. From this base line, it adds two standard deviations to create the upper band and subtractstwo standard deviations from the base line to create lower band.

By utilizing price volatility, Bollinger Bands adjust automatically to market conditions. As prices get more volatile, the bands widen, moving further away from the base line. During periods of decreased volatility, the bands will contract, creating a visual ‘squeezing’ of the recent price action. A touch of the lower band can signal a potential oversold condition, or it can suggest additional weakness that could be seen accelerating. A touch of the upper band could be a sign of a possible overbought condition, suggesting a reversal in trend is coming. Of course, this could also be indicative of strength in the stock and it could run quickly higher.

It’s been said that the stock market can remain irrational much longer than you can likely remain solvent. While these conditions could be signaling a move one way or the other, it’s important to remember that these indicators and signals of market action are not predictive. This is why countertrend trading can be so risky and difficult.

For example, a bearish countertrend trader might consider selling short shares of a security when price touches or breaks through the upper band, potentially signaling that there may be a shift in the trend, and buying back shares when the price touches or breaks through the lower band.  In the chart below, you can see that there are instances when this approach works and those when it does not. The recognition that technical analysis is not predictive can be very helpful. With short trading and the potential for unlimited risk, it’s imperative to have a disciplined exit plan and be willing to exit the short position once you’re proven wrong about the trade.

Source: StreetSmart Edge®

Combining countertrend indicators

Rather than relying on one indicator, some traders will combine two or more countertrend indicators in hopes of identifying potential price reversals more clearly. For example, a trader might combine Relative Strength (RSI) and Bollinger Bands and only act when the two are in agreement.

Combining overbought/oversold indicators: RSI and Bollinger Bands

When a bearish countertrend trader uses RSI and Bollinger Bands together, he’s looking for price to simultaneously touch or breakthrough the upper band and for the 4-day RSI to rise above the 70% line and then falls below it again. When this happens, it’s seen as a potential bearish countertrend alert signal. On the other hand, when price simultaneously touches the lower band and the 4-day RSI drops below 30% and then rises above it again, this is considered to be a potential bullish countertrend alert signal.

Source: StreetSmart Edge®

Identifying short-term pullbacks: overbought/oversold indicators and moving average

A common approach to countertrend trading is to use one tool to identify when the major price trend for a given security is in a downtrend, and then use another tool to identify when the price is overbought within the context of that longer-term trend. Bearish countertrend traders might look to sell short after an advance within an overall bearish long-term trend by combining an overbought/oversold indicator, with a trend indicator like moving average to help identify the major price trend.

RSI and a 200-day moving average

For example, if we look at XYZ using a 4-day RSI and a 200-day moving average, a bearish countertrend trader looking to sell short on a short-term rally would only consider selling the security if the 4-day RSI rises to an overbought level (70% or more) then falls below it and the security’s price is below the 200-day moving average.

Source: StreetSmart Edge®

Bollinger Bands and a 200-day moving average

Traders may also consider using a filter to countertrend trade in the direction of the major trend. In this example, a bearish countertrend trader would only consider selling short the security if the price was below the 200-day moving average and the price touches or breaks through the upper Bollinger Band, indicating a possible shift in the trend may be coming.

Source: StreetSmart Edge®

Summary

Countertrend trading is enticing to many traders because it holds the potential to capture more of a given price move by getting in earlier and/or out later than a trader who utilizes a trend-following approach. The danger is that countertrend trading at times involves “swimming against the tide.”  For this reason many traders who choose to engage in countertrend trading also combine several countertrend indicators to act as confirmation and/or utilize a trend-following filter and then take only countertrend trades that are line with the major trend.

Key Strategy Considerations - Analysis Approach
Key Strategy Considerations: Analysis Approach
Trend-Following in Bearish Trading
Trend following in bearish trading

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Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern or investment strategy.

Past performance is no guarantee of future results.

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