Bullish countertrend trading involves buying securities during a pullback against the prevailing trend in anticipation of a reversal to the upside. This is surely an aggressive approach as the trader is trying to pick the bottom, rather than allowing a trend to show itself before acting. Countertrend traders may use a similar approach to exiting their profitable trades by ‘selling into strength’. This trader is nimble and needs to capitalize on a move as quickly as possible to minimize risk.
The primary advantage to using a countertrend strategy is the potential for larger profits by entering the position closer to the near term low. Conversely, trading with the trend offers the trader more comfort and consistency because, as one adage suggests, ‘the trend is your friend’. By their nature, countertrend traders are aggressive and willing to take on substantial risk. Let’s look at some considerations of this aggressive approach.
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 turning point is very 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 paramount.
Generally speaking, countertrend trading requires even more discipline and risk management. Entering trades with well-established exit strategies will help this trader to capitalize when they’re right but keep downside to a comfortable level.
Using countertrend tools as a catalyst to enter a trade
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 momentum selling and principle 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 a 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. Many traders use 14 days to calculate RSI. 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 bullish countertrend trader may consider buying the security when the 4-day RSI falls to a generally accepted oversold level (30% or less), and then rises back above it, generating a signal that bullish sentiment may be gaining momentum. Then consider selling it when the 4-day RSI rises to a level generally thought to be overbought, (70% or higher), and then falls below it, generating a signal that bearish sentiment may be gaining momentum.
Countertrend catalyst example: Bollinger Bands®
Bollinger Bands are a technical analysis indicator that helps to identify situations where a security’s price has 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 subtracts two 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.
Here’s an example chart displaying price action relative to Bollinger Bands. Notice the arrow showing that the stock trended lower against the lower Bollinger Band for three weeks before finding its near term bottom reflected in the box. This is an example of the analysis not being predictive. Buying any one of those five previous touches of the lower Bollinger Band would have resulted in immediate losses rather than a quick trend reversal. In the boxes we see possible entry points signaled exclusively by Bollinger Bands.
Combining countertrend indicators
Rather than relying on one indicator, some traders will combine two or more of these counter indicators with the goal of identifying potential price reversals more clearly. For example, a trader may combine Relative Strength Index (RSI) and Bollinger Bands and only act when they are giving the same signal. When monitored together, the trader is looking for the price to touch or fall through the lower Bollinger Band and simultaneously reflect a 4-day RSI below the 30 line. On the chart below, you can see some instances when the stock’s price hit the lower Bollinger Band at the same time the 4-day RSI is in oversold territory.
Identifying short-term pullbacks: Overbought and oversold indicators and moving averages
A common approach to countertrend trading is to use one tool to identify when the major price trend for a given security is in an uptrend, and then use another tool to identify when the price is oversold within the context of that longer-term trend. Bullish countertrend traders might also look to buy on pullbacks within an overall bullish long-term trend by combining an overbought/oversold indicator, with a trend indicator, like moving averages, to help identify the major price trend.
For example, if we look at the chart below using a 4-day RSI and a 200-day Simple Moving Average (SMA), a bullish countertrend trader looking to buy on a short-term pull back would only consider buying the security if the 4-day RSI falls to an oversold level (30% or less) then rises back above it and the security’s price is above the 200-day moving average.
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 bullish countertrend trader would only consider buying the security if the price was above the 200-day moving average, which helps define if the stock is a trend and the price touches the lower Bollinger Band, indicating a possible shift in the trend may be coming.
Countertrend trading is enticing to traders because of its potential to capture more of a given price move. The danger with this approach is that the trader is often ‘swimming against the tide.’ For this reason, many traders who engage in countertrend trading will combine several countertrend indicators to act as confirmation. While combining indicators helps create a body of evidence to support or oppose a viewpoint, the heightened risk encourages the trader to be disciplined with their risk management approach.