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Contrarian Trading – Which category are you in?

Contrarian Trading – Which category are you in?

 

It is human nature to look to buy low and sell high rather than to look to buy high in the hope something goes even higher or sell low in the hope something goes even lower. This is also true in currency trading, especially with retail forex traders (and for professional traders as well). When I first became aware of charting the Forex Market, those who traded technically were essentially trend traders who looked to buy or sell on breakouts in the hope that momentum would continue in that direction once key chart points or formations were broken.  While many technical traders and systems still follow this path, others cannot shake human nature and look for “bargain” levels to establish positions. Contrarian trading, otherwise known as contra trading, is a term used to describe fading a move and/or positioning against a move or trend in the market.

 

I use counterpunch, which is also boxing word, to describe contrarian trading. In boxing counterpunch may be defined as a counterattack that occurs right after a boxer throws a punch to take advantage of an exposed position. In forex trading, it may be defined as fading a trend or a market move (on any time frame) in the hope of establishing a long position at a relatively cheap level or a short position at a relatively expensive level on the expectation that the move will reverse from around the entry level and provide a profit opportunity. However, not all contrarian trading is the same and different approaches involve different risks, depending on whether you are looking for levels to establish with the prevailing trend or against the trend and whether you have a short or longer term view. In this regard, I divide contrarian trading into four categories (note this is valid for all time frames):

 

1)     Counterpunch against the trend

2)     Counterpunch a correction to go with the trend

3)     Counterpunch during a congestion or consolidation

4)     Counterpunch with a longer term view and a plan based on a favorable risk/reward

 

1) Counterpunch against the trend:

 

This is the most tempting for human nature, especially in a strong trend, as each successive high or low makes it hard to jump on with the trend and tempts trading against it. The timing in such an approach is important as it is hard to hold on to a position if a new high or low is made following your entry, mainly because it is often hard to judge how for the trend might run. Perhaps more important is when to take a profit if you time the entry right.  The reason for this is the snapback in favor of the trend tends to be quick once the contra move runs out of steam. For this reason, I do not suggest looking to milk the last pip and to take your profits quicker when counterpunching against the trend than when trading with the trend. It is easy to see a profit quickly wiped out and a loss seen (depending on where you place your stop) if you stay at the party too long in this type of trade. It is also easier to get stopped out if using a tight stop.

 

2) Counterpunch a correction to go with the trend

 

This type of trade often offers a good risk/reward trade and the use of a stop may be as important as the timing of the trade. Unlike the prior example, in this case, a quick snapback in favor of the trend works in your favor and there is generally less of a rush to take profits as the market resumes the prevailing trend. One reason for the snapback is that once a profit taking move runs its course, there tends to be an absence of bids or offers (as the case may be) to absorb the flows in favor of the trend. In this case, it is important to find a stop at a level that allows the trade time to work and if taken out, tells you that your trading scenario is wrong.

 

3) Counterpunch during a congestion or consolidation

 

This type of contra trade can be profitable if one recognizes early on that the market is congesting or consolidating. Often this is not clear until after the fact so testing the waters with a contra trade and repeating the trade until it stops working is a strategy that can provide dividends. The key here is to use a stop that supports the range view but don’t overstay your welcome if the picture changes. In other words, trade the range while it works but don’t be stubborn if the range breaks.  My preference is to trade one side rather than looking to trade both sides of a range.

 

4) Counterpunch with a longer term view and a plan based on a favorable risk/reward:

 

This type of contrarian trade requires a trading plan and money management as in all likelihood the position will be initially under water. In this case, you are not looking to bottom or top pick but rather establish or scale in to a position that offers a good risk/reward based on your analysis of the market. Sometimes you are looking for value when you see a currency pair under or overvalued relative to its mean. Money management is crucial, as always but perhaps more so in this type of trade as you may be initially going against a prevailing trend or momentum, making staying power a key to its success. In this regard, placing a stop that allows the trade time to work and limits any losses to acceptable levels in case the trade does not work is also critical. It is also important to take the emotion out of this type of trade given the chance that you may initially be sitting with a losing position. 

 

The point is that not all contrarian or counterpunch trades are the same, each posing a different risk and requiring a different strategy. In all cases, it pays to trade with a plan and not succumb to human nature by buying or selling just because your gut says the price is too high or low. Prudent money management, use of stops and sound analysis (including a rationale for a trade) are important tools, especially for contrarian traders and should be part of the mix when considering a trade. If you contrarian trade, be aware of what category you fall into and adjust your strategy accordingly.

 

 

Jay Meisler has been trading the forex market for more than 30 years, as an interbank dealer, fund manager and independent trader. He is a co-founder of  Global-View.com  the leading forex discussion site and home of the original forex forum. Global-View is a place where traders come for forex trading ideas, latest rumors, flows and breaking news.

 

 

 

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