Combining Trend and Countertrend Indicators

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Combining Trend and Countertrend Indicators

One of the oldest trading adages is that “the trend is your friend.” Because the trend specifies the prevalent direction of price movement for a certain tradable asset, going with the present trend is more profitable than fighting against it. Nonetheless, it is natural to desire to acquire at the lowest possible price and sell at the greatest possible price. In the financial markets, the only way to achieve this is to try to “buy the bottom” and “sell the peak,” which is a countertrend method to trading.

Every trading day, the battle rages between those wanting to purchase or sell into an established trend and those aiming to buy around a low and sell near a high. Both sorts of traders have compelling reasons for why their method is preferable. However, in the long term, combining these two apparently dissimilar techniques may be one of the finest options. The simplest approach is often the best.

A Combined Approach

Two acts aid in the effective combination of trend-following and countertrend techniques:

  1. Find a technique that performs a reasonable job at detecting the longer-term trend.
  2. Find a countertrend strategy that is effective in highlighting pullbacks within the longer-term trend.

While determining the best way may take some time and effort, showing the concept’s potential use may be accomplished with a few easy strategies.

Step 1:Identify the Longer-Term Trend

A stock chart with the 200-day moving average of closing prices is shown in Figure 1. From a trend-following standpoint, we can simply declare that if the most recent close is higher than the current 200-day moving average, the trend is “up,” and vice versa.

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Figure 1: Price with 200-day moving average.

Image by Sabrina Jiang © Investopedia2021

However, for our purposes, we are not seeking for a trend-following system that will always provide buy and sell signals. We are only attempting to identify the prevalent tendency. As a result, we will now provide a second trend-following filter. Figure 2 shows that we have also included the 10-day and 30-day moving averages.

Figure 2: Price with 10-day, 30-day and 200-day moving averages.

Image by Sabrina Jiang © Investopedia2021

So now our rules will be as follows:

  1. If the 10-day moving average is higher than the 30-day moving average AND the most recent closing is higher than the 200-day moving average, we will call the current trend “up.”
  2. If the 10-day moving average is lower than the 30-day moving average AND the most recent closing is lower than the 200-day moving average, we will label the current trend as “down.”

Step 2:Adding a Countertrend Indicator

There are literally hundreds upon dozens of different countertrend indicators to pick from. We will utilize something extremely basic and rather short-term in nature for our purposes, since we are seeking for short-term pullbacks inside a larger longer-term trend. The oscillator is the common name for this indicator. The calculations are straightforward:

A = the 3-day moving average of closing prices

B = the 10-day moving average of closing prices

The oscillator is simply (A – B)

Figure 3 shows the identical price chart as Figures 1 and 2, but with the oscillator shown underneath the price movement. When the underlying security’s price falls, the oscillator falls below zero, and vice versa.

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Figure 3: Price with 3/10 oscillator.

Image by Sabrina Jiang © Investopedia2021

Step 3

So, let’s integrate the two ways we’ve covered so far into a single method. Figure 4 depicts the same bar chart as the previous three Figures. On this one, the 10-day, 30-day, and 200-day moving averages are placed on the price chart, along with the oscillator shown below.

Figure 4: Looking for oscillator reversals to the upside in an established uptrend.

Image by Sabrina Jiang © Investopedia2021

An informed trader should search for situations in which:

  1. The 10-day simple moving average is higher than the 30-day simple moving average.
  2. The most recent closing is higher than the 200-day moving average.
  3. AND today’s oscillator is higher than yesterday’s oscillator
  4. Yesterday’s oscillator value was both negative and lower than two days earlier.

The fulfillment of this set of conditions shows that a pullback inside a longer-term uptrend has occurred and that prices are poised to rise. The aforementioned conditions describe a situation in which the trend shows that the stock will continue to rise, but the investor will not be acquiring shares at the apex of the cycle.

The Drawbacks

There are several possible drawbacks to the strategy outlined in this article. First and foremost, no one should expect the proposed strategy to produce continuous trading returns. It is not provided as a trading strategy, but rather as a possible way for generating trading signals. The strategy is essentially one way to incorporate trend-following and countertrend indicators into a single model. While the premise is good, a prudent trader would need to test any strategy before using it in the market and risking real money. Furthermore, there are additional critical factors to consider that go well beyond just providing entry signals.

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Other pertinent questions to ask and answer before using any trading strategy are:

  • How will positions be sized?
  • How much of one’s money will be put at risk?
  • When and where should a stop-loss order be placed?
  • When should you take a profit?

The Bottom Line

This is only a selection of the factors that a trader must evaluate before commencing to trade any certain strategy. Nonetheless, with those cautions in mind, there seems to be some potential in combining trend-following and countertrend tactics in an attempt to purchase at the most advantageous periods while remaining committed to the overall trend in play.

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