After you’ve been trading for awhile, you’ll begin to learn that, when you get right down to it, there are only 2 ways to trade: with the trend — or against it.
When you trade with the trend (in the direction that price is currently moving) this is called trend trading. When you trade against the trend (against the current direction of price) this is called counter trend trading.
Both of these methods have their strengths and weaknesses, so let’s take a look at both.
Trend Trading Simplified
Trend trading is probably one of the easiest types of trading to understand, and one of the hardest to execute. It’s hard to trade with the trend for one reason, your emotions and your basic human need to be right.
With trend trading you are betting that the current direction of price will continue. Which it rarely does. Believe it or not. And this will make you angry, very angry.
If you trade with the trend (trend trading) it means that you buy breakouts in an attempt to catch the beginning of rising prices. Unfortunately, if you do this, you will be wrong — a lot — at least 60% of the time or more.
That’s because prices trend only 30-40% of the time.
The way you make money as a trend trader is when you catch that rare trending stock and price moves in your direction 30%, 40%, 100% (or more) and you grab a huge gain that offsets the many small losing trades.
Like this trade in BONT that we caught earlier this year —
Do you see the breakout from the long base in January? From there price pushes to new highs and then just keeps going and going and going.
That’s the type of move trend trading dreams are made of and the true definition of letting your profits run.
Here price moved from $3.50 a share to over $9.00 a share, for a gain of over 257%! A move like that will wipe out a slew of small -5% losses.
When this happens your account will fill with cash.
And, believe it or not, that’s where the problems begin.
Not only will you have to deal with 60-70% losing trades while you wait to catch that one trending stock, you will also learn how hard it is to actually let that trending stock run once you find it.
You will be deathly afraid that this trending trade will turn on a dime and take away all of your profits. Because the markets can do that, very quickly.
See how price has been cruising higher since early May and then in the last 2 days it has crashed?
You will be petrified of this happening to you.
You will be so petrified that every day that your account is growing you will want to close that winning trade and bank those profits.
The only trouble is that you need to keep the trending stocks open for as long as you can because you need those really big winners like BONT to cover all of those small losses that you will have from taking trades that do not develop into trends.
Which brings me to the second method of trading…
Trend Fading Simplified
Some people get so frustrated that they cannot keep trending stocks open that they will turn to the dark side and start fading trends. Or trading counter to the trend — hence the name “counter trend trading”.
As I mentioned earlier, this means that you are betting that the current trend will end and that price will soon reverse.
This means, that when a breakout happens — you short it. When you trade this way, you will be right 60 – 70% of the time.
Which is awesome. And it looks like this:
Do you see how, after the breakout, price moved in that direction for only two bars and then immediately went in the other direction?
That’s a fakeout. And if you went short during either of those bars, anticipating the breakout to fail, you’d be loving that trade.
The trouble with counter trend trading (and yes there is trouble — sorry!) starts with the 30-40% of the time when you are wrong. And you fight it. And you buy more when price moves against you.
And it keeps moving against you.
And you finally figure out how trend traders make money — and how and why trends exist.
Let me show you on a chart:
Imagine you bought DSKX below when it broke to new highs in late May.
Initially you would have been right, and if you closed after a couple days you would have made money.
But what if you get greedy (you will) and you kept holding out for more profits (you will) and then price turned against you.
Now you see your profits being eaten away and soon price breaks out again — and you are losing money.
But you are not going to close — you are in it to win it at this point. So you fade more on the next breakout and you break the cardinal rule of trading — you add to a loser.
But price keeps going higher. And now you are -50% underwater with no end in sight.
And now you see how trends develop.
Because there will always be those who deny reality.
If you can’t accept when a trade moves against you you will get hurt whether you trade the trend or fade the trend.
So Which Method Is Better?
So which method is better, trend trading or counter trend trading?
Is it better to buy breakouts and trade in the direction of the trend? Or is it better to fade breakouts and look to trade against the other traders piling into a trade?
Well that, my fellow retail trader, depends entirely on you. Because ultimately, that is what trading is all about. Learning what works for you. Learning what you can manage and how you see the market.
Do you like bigger wins and can you tolerate lots of smaller losses? Then trend following is for you.
Do you want a higher win rate and are you okay letting the bigger trends go? Then be a trend fader.
Or why not give both a try and see which method sticks!
Until net time…