Trend vs. counter-trend trading

Take a look at the chart in Figure 1.2, and the arguments for and against trend or counter-trend trading will leap at you from the page. You can easily recognize an uptrend: when prices run from the lower left corner to the upper right corner, you do not need to be a technician to identify a bull market.

Figure 1.2 Moving Averages Identify Value
Daily chart of MW, 26-day and 13-day EMAs

The slow EMA (exponential moving average) rarely changes direction; its angle identifies the increase or the decrease of value. The faster EMA is more volatile. When prices dip into the zone between the two lines during an uptrend, they identify good buying opportunities. Prices are attached to values with a rubber band; you can see that prices almost always get only so far away from the EMA before they snap back. When a rubber band extends to the max, it warns you to expect a reversal of the latest move away from value.

It seems simple enough to buy and hold— until you realize that this trend, just like any other, is clear only in retrospect. If you had a long position, you’d be wondering every day, if not every hour, whether the uptrend was at an end. Trying to ride a trend is like trying to ride a high-strung horse that keeps trying to shake you off and at times rolls on the ground to get rid of you. Sitting tight requires a great deal of mental work!

Counter-trend trading has its own pluses and minuses. You can see how prices keep outrunning themselves time after time. They keep getting away from value, only to snap back to it. Buying below value and shorting when prices rise too far above value has a different attraction: the trades tend to last only a few days. They require less patience and make you feel much more in control. On the minus side, the profit potential of each trade is smaller.

This is the choice you need to make: you can trade in the direction of a long-term moving average or you can bet on prices returning to their moving average after they become overextended. The first approach is called trend-following; the second, counter-trend trading.

In his brilliant book Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis, Richard Weissman draws a clear distinction between three types of traders: trend-followers, mean-reversal (counter-trend) traders, and day-traders. They have different temperaments, exploit different opportunities, and face different challenges.

Most of us fall into one of these trading styles without giving it much thought. Very few of us make a conscious business decision. For example, when I began to trade, many serious and intelligent people told me I had to be a trend-follower. I did it for many years, but my heart was not in it. After years of trying to be a trend trader, I came to realize that what I really wanted to do was counter-trend trading. I have been happier and much more profitable ever since. Many of my friends, on the other hand, only trade trends and would not touch a counter-trend trade. You have to figure out who you are, and trade accordingly.