Thursday, October 11, 2007

Trend Trading or Counter Trend Trading - Which is Best?

When I first starting designing and testing trading systems, back in the early days of personal computers and trading software, I immediately gravitated toward counter trend trading. I would put up a stochastic, before I even knew what it was measuring, and my eye went right to all the divergences. A divergence is a basic counter trend pattern, where the price makes a new high, for example, and the indicator makes a corresponding lower high, thus forming a divergence with the price. The idea is that the new price high was not confirmed by momentum, which in this case was losing strength. When this pattern is seen, it is thought the market might have put in a high for the move, and it might turn around and go in the other direction.

I liked the idea of picking tops and bottoms. I was getting really good at it, at least on paper. I thought I had found the Holy Grail of trading. It all looked so easy. Almost every new high or new low on the chart was accompanied by a very clear divergence pattern. These patterns just jumped off the charts, screaming at me. I thought I had found the key to my trading plan, and it was going to be to be able to pick the point of a trend change. In other words, I was going to become an expert at picking tops and bottoms.

Then I started trying to trade all these easy patterns with real money. For some reason, whenever I would take a trade on one of these patterns the market didn't know it was supposed to reverse. It would just keep going in the direction it had been going. I would get several divergences and the results would be the same. That is, of course, until I got so burned out trying to catch the reversal and I would give up. Then, like magic, the perfect divergence pattern would appear, but I would not be in the trade.

I would caution anyone who thinks that they can pick the spot, with any accuracy, of a top or bottom in the market. I know many gurus and market timers claim to be able to do it. It can be quite gratifying to pick the top of a market, especially when all the media and analyst are on one side of the market, and you go the other direction and win. It gives you a very brief sense of superiority. You could see something that nobody else could, and you made a profit with this knowledge. However, after engaging in this activity for any length of time, one should review the account statements to really see if this has been a profitable way to trade.

It is remarkable how the eye can pick out major highs and lows on a chart, and to see many reasons why the top or bottom was so obvious. Maybe there was a classic three drives to a high pattern, or a head and shoulders pattern, along with diverging momentum or volume. It makes picking tops and bottoms look so easy. But if you analyze the chart more carefully, youll probably find two or three times as many set-ups that fail. The mind somehow glosses over the failed set-ups and goes right to the successful patterns.

After many frustrating attempts unsuccessfully using the stochastic indicator, I decided to study with the person who developed the indicator. I flew to Chicago to study with George Lane. Here was the guy who developed the indicator that almost everyone at that time was using to spot divergence patterns, and he talked me out of trading divergences, except in rare case. He only used the stochastic as a confirmation if many other conditions of trend change were present. I still like that indicator, but I use it in an entirely different way now. The time spent studying with him probably saved me years of frustration and a lot of money avoiding losses.

When thinking about trend change there are some things to keep in mind. First, trends tend to persist; often longer than you think is logical. When trends are up they often climb that wall of worry. Worry that the market will collapse without warning and take away your profit. Worry that the fundamentals don't justify the prices being traded. Logic might dictate taking profits, but there is worry of leaving money on the table. Uptrends tend to end more leisurely, at least in the stock market. For the public, it is easier to decide to enter a market or take profits in the calm of rising prices, where only greed is the factor. In down markets, traders often panic, and margin calls with fears of losing your home are often a motivator that results in more urgency. Therefore, bottoms can form quickly and sharply. Futures markets seem to be a bit more even regarding uptrends and downtrends, due to the nature of the mix of traders involved. A sideways trending market, or a market with a perceived lack of trend, will often lull traders into complacency, and with attention elsewhere, breakouts into a trend can be missed.

To summarize, I find the best strategy is to find the main, confirmed trend, whatever indicator or method used to determine that trend. Then trade only in the direction of that confirmed trend. Trading pullbacks, such as flag patterns, will usually offer the safest entry points. Trends have smaller cycles within the larger cycle. There are usually pullbacks within the longer term trend. One can still trade turning points of these smaller cycles, as long as they are in the direction of the longer-term trend. I will accept kicking myself for the few times I see major tops or bottoms that I will most certainly miss. This is a small price to pay for missing many losing trades resulting from trying to buck the trend. There are always trends somewhere, and in some timeframe. Going against the trend is like jumping into a river flowing rapidly in one direction, and trying to swim in the opposite direction. It is difficult and exhausting to do. It's much easier to float down the river in the direction that the current wants to go. The ego is more gratified in going the opposite way. The ego is also one of the most difficult aspects of trading to overcome.

Doug Tucker has a blog with daily commentary on stock indexes, precious metals, and other markets. There are many articles on technical analysis and indicator design and interpretation. To visit go to: