One of the principles of technical analysis is that price moves in trends. Every trend consists of periods when the price moves in the direction of this trend and smaller periods of counter trend corrections.
Trend following strategies imply that a trader opens a position in the direction of the main trend. In other words, buys in an uptrend and sells in a downtrend. The best time for entering the market using this approach is when a correction ends and the main trend resumes. “Buy low and sell high” is traders’ favorite mantra.
Counter-trend traders do not want to wait for a correction to pass. If the market is in an uptrend, they can sell when the price reverses from resistance and set a target near support. Their motivation is that the price has already gone too high so that it’s bound to decline.
Do these approaches have similar risks or not? Which one can offer trader greater profit?
Most traders can determine the current trend. The tricky part is to decide how to act. Let’s continue with the uptrend example. Trend trading implies that you will either buy at support or on the break of resistance. In the first case, you will use such instruments as trendlines and Fibonacci retracements. In the second case, you will be able to use continuation chart patterns like triangles, flags, and wedges.
Some traders will buy at the point 1 (trendline support and Fibonacci retracement level) or 2 (a break of a “Flag” pattern), some will wait for the point 3 (a break above the previous high). Of course, the lower you buy, the bigger your profit can be.
Take profit. You can set your profit target at the previous high of the uptrend (low of the downtrend) or even levels beyond it if you are more confident in your trade.
Stop Loss. Notice that when you ride a trend, you can use a trailing stop that follows the trend. Be aware, however, that it may be not very easy to decide where to move a stop loss. The risk will be that a dipper correction will make the market hit your stop and close your order.
Scaling in. It’s allowed to add to a position when you follow a trend if the market already moved in your favor and your trade became profitable. This way your potential profit will increase. Don’t forget to adjust your risk management if you do this. You can also plan to start with a smaller trade than usual (for example, buy at the point 1) and then increase it when the price gets above point 2. This tactic will reduce your risk.
Counter trend trading
Counter trend strategies aim to determine a trend’s reversal point. Traders who use this approach are taking hints from reversal candlestick patterns (pin bars, evening/morning starts, etc.). They also apply oscillators like MACD or RSI to see whether the market has become overbought/oversold and whether there’s a divergence between the price and the indicator. If these signs are present, traders open positions counter the previous trend.
A trader may decide to sell at the point 1 as the price formed a candlestick with a long upper shadow (a negative sign) and the MACD indicator didn’t confirm the price’s high.
Take profit. It’s harder to find a place to fix profit when you trade counter trend. The challenge is not to get too greedy. Remember that you bet against the market. Some trends can turn into a sideways market limiting profit of a counter trend position. The initial trend can also resume fast and not let the price correct too much. As a result, be careful and manage the risks.
Stop Loss. The location for a stop loss order in such a trade is natural. Traders put their stop losses behind the extreme point of the price from which a correction has started. The stop loss will likely be smaller than the one you would use if you traded the trend.
Scaling in. It’s not a good idea to meddle with your position size when you trade counter trend. The trade can be very short-term, so you risk getting yourself in an uncomfortable situation if you try to add to a trade. And never add to a losing position as it may lead to a bigger loss.
As you can see, both trading approaches have their specific traits. Both can generate good trade signals, but each requires its own risk management strategy. The common wisdom of traders is that counter trend trading requires much more experience and beginners should start with trend following. Practice and see which way works for you!