In the world of trading and investing, there are two main approaches to profiting from the movement of asset prices: Follow Trend (Trend Following) and Counter Trend (Contrarian Trading) techniques. These methods represent different philosophies for navigating the markets, each with its own risks, rewards, and strategies. Understanding these techniques is crucial for both novice and experienced traders as they provide distinct ways of identifying market opportunities and managing trades.
In this article, we will explore both the follow trend and counter trend trading techniques, their key characteristics, and how traders use them across various markets like stocks, forex, and cryptocurrency.
- What is Follow Trend Trading?
Follow trend trading, often referred to as trend following, is a strategy that aims to capitalize on the continuation of an existing trend in the market. Traders using this technique believe that once an asset (such as a stock, currency pair, or cryptocurrency) establishes a trend, it is likely to continue in the same direction for a certain period.
The underlying assumption is that “the trend is your friend”, meaning that markets tend to move in prolonged trends, and jumping onto an already established movement is a less risky way to profit.
How Follow Trend Trading Works
Follow trend trading involves identifying an upward or downward trend and entering trades that align with that trend. Here’s how it works:
- Identifying the Trend: Traders use tools such as moving averages, trendlines, or momentum indicators like the Relative Strength Index (RSI) to identify whether a market is trending up (bullish) or down (bearish).
- Entry Points: In a bullish trend, a follow trend trader would look to enter long (buy) positions, expecting the price to continue rising. In a bearish trend, they would take short (sell) positions, expecting the price to keep falling.
- Holding Positions: The aim is to stay in the trade as long as the trend remains intact, only exiting when there are signs that the trend is losing strength or reversing.
Advantages of Follow Trend Trading
- Simplicity: Traders only need to recognize the direction of the trend and align their trades accordingly, making it an easier strategy for beginners to grasp.
- Potential for Large Profits: Trend following can yield significant profits if the trend is strong and long-lasting. Large price moves can occur in trending markets, particularly during bull or bear markets.
- Fewer Trades: Since follow trend traders hold positions for a longer time, they make fewer trades, which can result in lower transaction costs.
Disadvantages of Follow Trend Trading
- Lagging Entry: Traders typically enter a trend after it has already started, which means missing out on the initial price move. If the trend is near exhaustion, there may be limited profits.
- False Breakouts: Sometimes the market appears to be trending but then quickly reverses (a phenomenon called a false breakout), leading to losses.
- Volatility Risk: In choppy or sideways markets, trend following can be challenging as there may be no clear trend, leading to losses or frequent stop-outs.
- What is Counter Trend Trading?
Counter trend trading, also known as contrarian trading, involves betting against the prevailing market trend. Traders using this strategy seek to profit from market reversals, assuming that trends often end and reverse after reaching extreme levels.
Counter trend traders believe that markets move in cycles and that prices will eventually reverse, even after prolonged trends. They aim to buy in a downtrend or sell in an uptrend, anticipating that the market is overextended and due for a correction or reversal.
How Counter Trend Trading Works
Counter trend trading involves taking positions in the opposite direction of the current trend. Traders look for signs of trend exhaustion or overbought/oversold conditions to time their entries.
- Identifying Reversals: Traders use indicators like the RSI or stochastic oscillator to identify when an asset is overbought (in an uptrend) or oversold (in a downtrend). Candlestick patterns, such as hammer or shooting star, may also signal a reversal.
- Entry Points: In an uptrend, counter trend traders would take a short position, expecting the price to reverse and fall. In a downtrend, they would take a long position, expecting a rebound.
- Tight Stop Losses: Since counter trend trading goes against the prevailing trend, traders typically use tight stop losses to minimize risks in case the trend continues.
Advantages of Counter Trend Trading
- Profit from Reversals: Counter trend trading can be highly profitable if the trader successfully identifies the market turning points. Large gains can be made if the reversal leads to a significant price move.
- Early Entry: Traders can enter trades before a new trend starts, potentially capitalizing on the full movement of the reversal.
- More Frequent Opportunities: Markets tend to have corrections or pullbacks within larger trends, providing frequent opportunities for counter trend traders.
Disadvantages of Counter Trend Trading
- High Risk: Counter trend trading is inherently riskier because it involves trading against the existing momentum. If the trend continues, losses can mount quickly.
- Requires Precision: Timing is crucial in counter trend trading. Entering too early or too late can result in losses, and it requires careful analysis to identify genuine reversals.
- Shorter Trade Duration: Reversals are often shorter-lived than trends, meaning counter trend trades may need to be closed quickly, requiring more active management.
- Tools and Techniques for Follow Trend and Counter Trend Trading
Both follow trend and counter trend traders use various tools and techniques to support their strategies. Some of the key methods include:
Moving Averages
- Follow Trend: Traders use moving averages, such as the 200-day moving average, to confirm the direction of a trend. If the price stays above the moving average, it signals a bullish trend; below it, a bearish trend.
- Counter Trend: When the price moves too far away from the moving average, it might signal overextension, providing an opportunity for counter trend trades.
Trendlines and Channels
- Follow Trend: Traders draw trendlines along the highs or lows of price movements to visually confirm the trend’s direction and strength.
- Counter Trend: If the price breaks a well-established trendline, it may signal a reversal, prompting counter trend traders to take action.
Relative Strength Index (RSI)
- Follow Trend: When the RSI is trending, traders look to stay in the direction of the trend as long as the RSI stays in the bullish or bearish zone.
- Counter Trend: The RSI can help identify overbought (above 70) or oversold (below 30) conditions, suggesting a potential reversal.
Fibonacci Retracement Levels
- Follow Trend: Traders use Fibonacci retracement levels to find potential points where the price may pull back in a trending market, offering a good entry for trend-following trades.
- Counter Trend: A pullback to a significant Fibonacci level (like 61.8%) can signal a reversal, providing an opportunity for counter trend trading.
- Which Strategy is Right for You?
Choosing between follow trend and counter trend trading depends on a trader’s risk tolerance, market experience, and personal preferences. Here are some factors to consider:
- Follow Trend Trading is ideal for traders who prefer a less risky and simpler approach. It works well in markets with strong, prolonged trends, such as during bull markets in stocks or major currency movements in forex.
- Counter Trend Trading is suitable for traders who are comfortable with higher risk and enjoy timing reversals. It requires a more advanced understanding of market dynamics and technical analysis.
Ultimately, many traders use a combination of both techniques, adapting to market conditions. For instance, in a strongly trending market, a trader may follow the trend but switch to counter trend tactics when signs of reversal emerge.
Both follow trend and counter trend trading strategies offer distinct advantages and challenges. Trend following provides a straightforward approach that benefits from prolonged market movements, while counter trend trading aims to capitalize on market reversals and corrections.
By understanding the mechanics of these techniques and learning when to apply them, traders can enhance their market strategies and potentially improve their profitability across different asset classes like stocks, forex, and cryptocurrencies. The key is to remain flexible, adapting to market conditions while managing risk effectively.