When a security gets extended in one direction (why Zayn? why?) or another, there may be opportunity to take advantage of reversion to the mean by engaging in a counter-trend trade. Counter-trend trades, regardless of the timeframe, are lower probability by nature because you are attempting to trade against the underlying trend. Given the excitement in the currency markets and oil as of late, I thought it may be beneficial to explain what conditions I look for when attempting to capitalize on counter-trend moves.
1. The first step in my process is to find things that are extended from their mean, which for me is the 200 period simple moving average. Of course the threshold for it showing up on my radar is somewhat subjective based on what the security has done historically, but anything that’s ~ 20% or more above or below the 200 period simple moving average is a decent place to start.
2. Next, I want to look at some data regarding sentiment and seasonality, which I normally get from a service called sentimentrader. If sentiment is at historical extremes, that can help add some fuel to a short squeeze or sell-off that might occur if prices start correcting. From a seasonal perspective, I like to know how price behaves during certain months because small clues, such as prices ignoring what is normally a seasonally bullish period, can be a subtle hint from the market that there are larger forces at work.
3. After I’ve found something that’s extended and have a good handle on its sentiment and seasonality, I like to look at momentum using a 14 period RSI. What I’m looking for is a positive or negative momentum divergence, ideally on multiple timeframes, which for me is weekly and daily. Occasionally I might stay interested if there’s only a divergence on one timeframe, but for the most part I’d like to see it present on both.
4. As always, price is the most important variable. If the factors above look to be leaning toward one side of the trade, I’ll wait for price to give an entry at an area where I can clearly define my risk. Ideally, this is where I love to see a false breakout / breakdown. Not only do false moves often lead to fast moves in the opposite direction, but they provide a great risk/reward entry because I know exactly where I’m going to be wrong.
*Notice I used the word ideally quite frequently, that’s because very rarely will all of these factors line up perfectly, which is why there is some degree of subjectivity and room for error in these types of setups.*
To show how this works in practice, I’ll use a recent example of this setup in crude oil.
1. The first thing that stands out is how far crude oil prices are extended from the mean on both the weekly and daily timeframes. Current prices could rally almost 90% before reaching the 200 week simple moving average and 60% before reaching the 200 day. To me this says either prices have to consolidate for the moving average to catch up, or they have to rally back toward the mean. Of course there will be a lot of resistance along the way, but if prices have 60% upside before getting back to their average price, it’s worth a look to me.
|200 Week SMA||91.72||89.39%|
|200 Day SMA||77.39||59.80%|
2. In terms of seasonality and sentiment, there are strong tailwinds for a counter-trend trade present. First off, March-September is the best 7 month period of the year for crude oil, with average returns being positive in each month over the past thirty years. Additionally, the data suggests that sentiment is still quite bearish in oil while commercial hedgers continue to increase their long positions. I don’t know about you all, but I’d like to trade in the direction of the “smart money” hedgers who are currently adding to positions on the long side, even if they are still largely net short in aggregate.
3. In terms of momentum, RSI is diverging positively on both the weekly and daily timeframes, which is exactly what I like to see when attempting to time a counter-trend move.
4. The last, and probably best part about this setup is the false breakdown below the late January lows that allowed traders looking to capitalize on a counter-trend rally to clearly define their risk. A great entry was presented when prices broke and closed back above the January lows. It’s the perfect scenario because I know that below those lows, there is no reason to be involved on the long side. At the end of the day the market is going to do what it wants, at least this type of entry gives me a way to play the long side of oil with a higher probability of success and more well defined risk than blindly bottom fishing.
So there you have it, my process to approaching counter-trend trades. As you can see from the chart above, even with as nice of a setup as this was, crude oil is getting a bit frisky as it tries to stay above trendline resistance. The thing about counter-trend trades is that you’re going to be wrong a lot more than you’re right, which is why it’s important to wait for your pitch and make sure that the risk/reward is high enough to put capital to work. What a sufficient r/r is depends on a trader’s personal risk tolerance and trading plan, though I normally shoot for 7/1 or higher.
As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.