In the zero-sum game of financial markets, smaller traders look for opportunities to level the playing field. There is a long time saying that every trader will hear numerous times during their career that “the trend is your friend.” As accurate as this statement can be, the reality is that there are left-brain and right-brain traders. Some prefer nothing more than to look for opportunities to engage an existing trend. However, numerous traders have a psychological block when it comes to buying a market in the current trend.
Take, for example, traders who utilize the various forms of the U.S. equity index markets like the S&P 500, and its derivatives. This market has been trending higher for years, with every sell-off an opportunity to buy. However, analytic tools such as the CFTC’s Commitment of Traders Report, as well as broker sentiment tools for CFDs (contracts for difference), have consistently reflected a retail trading market that overwhelmingly tries to short the S&P 500.
Whether it is because you are naturally a contrarian or feel the mental freeze of trend following, these are real psychological variables that traders must face. The intent of this article isn’t to shame traders, but first to encourage you to call attention to your own subconscious bias. Self-awareness is healthy in all areas of life, and for a trader to perfect his or her craft, then self-awareness is an absolute necessity.
To help compensate for the challenges of counter-trend trading, below are the first 8 rules that I have developed over the last 12 years of trading.
1. Aim small miss small
Use less capital on counter-trend trades. That way, you can take multiple attempts, and when you are right, then you have the opportunity to make money on the reversal momentum regardless.
2. Thread a needle:
Use a tight stop when trying to target a top or bottom. Be precise in your entries, and know where your bias fails.
3. The Retest:
Remember that while there are V-shaped reversals, the retest (W type) rebounds often give very reliable signals.
4. Hold your winners longer:
This is key if you nailed a bottom or top, then the reversal is going to pay. One problem is that because reversal trading has a lower winning percentage, traders take profits too soon. However, because of the nature of this style, traders may use a 5:1 return on risk ratio or greater even.
5. Don’t exit at once:
This is for winners, scale-out of the position, this will allow runners to reach those broader objectives.
6. Know what time it is:
Remember Sun Tzu, you must know your market and how it behaves at various times, and the better times of day for trading a reversal. Also, you must know your internal clock and when you make the most accurate decisions in a day.
7. Listen to your emotions:
The reason why algorithmic trading trumps humans is that they trade without emotion. Humans are incapable of being emotionless. Rather than ignore your emotions, pay attention to your thoughts, feelings, heartbeat, and breathing patterns, and know when you are trading based on emotion or logic.
8. Learn to forgive:
This includes yourself. Revenge trading is the easiest and most painful way to lose money. When you are wrong, forgive yourself rather than trying to validate yourself.
What is important is that traders have guidelines and stick to them. I often encourage my colleagues to print out their own rules and keep them nearby to reinforce them throughout the trading days.
