Countertrend trading is the practice of trading against the prevailing trend of the market. The countertrend trade tries to capitalize on imbalances that regularly occur in financial markets. Frequently, strong price moves up or down in a relatively short period of time are likely to be over done. This condition is commonly referred to as overbought or oversold.
This trade is often compared to standing in front of a bus and hoping you don’t get run over. This can be true if the necessary elements aren’t implemented at the time of the trade. The necessary elements are:
Money Management – Put position on in 1/3 blocks. If conditions materially change that changes original premise in which trade was made, don’t discontinue buying the remaining 2/3 and take your loss on just a 1/3 position.
Maximum Trade Size – No more than 10% should be committed to any single trade.
Use Options for Countertrend Trades – Options limits total losses to the cost of the option, but you can exit a option position at a small loss if conditions change that make getting out the best choice at the time.
Buy options that have a premise that makes sense. For example, many strong stocks will get hit hard by indiscriminate selling that happens in a market in steep decline. Steep declines are usually caused by some shock event like 9/11 or most recently sub-prime woes. There will be countless opportunities in companies that have little or nothing to do with this financial contagion. In a sup-prme concerned market, a long position in a insurance company like Met Life (MET), a good company that has increased revenue every year since 03 with matching increases in net income. Cash (net income) will always be king.
Use simple Technical Analysis to confirm entry of position. Particularly use chart patterns in conjunction with market dynamics and fundamentals. The chart pattern for Met Life shows a double bottom which creates a price specific price for entry.
