Combining Trend and Countertrend Indicators
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One of the oldest adages in all of trading is that “the trend is your friend.”
The trend defines the prevailing direction of price action for a given tradable security.
As long as the trend persists, more money can be made by going with the current trend than by fighting against it.
However, many traders instinctively want to buy at the lowest price and sell at the highest price within a given time period.
This approach requires using countertrend signals to “buy the bottom” and “sell the top.”
Each trading day, a struggle plays out between those attempting to trade with the trend and those trying to time the market by buying near the low and selling near the high.
Both types of traders have strong arguments for their approach.
Interestingly, one of the best methods may involve combining these two seemingly different strategies.
Often, the simplest solution is the best one.
A Combined Approach
To successfully combine trend-following and countertrend techniques, two key actions are needed:
- Identify a method that does a good job of spotting the longer-term trend.
- Identify a countertrend method that highlights pullbacks within the longer-term trend.
Finding the perfect approach may take time and effort, but the concept can be highlighted using simple techniques.
Step 1: Identify the Longer-Term Trend
One way to identify the longer-term trend is by plotting the 200-day moving average of closing prices.
A stock’s price above the 200-day moving average indicates an uptrend, while a price below it indicates a downtrend.
However, adding a second trend-following filter can give more precision.
By adding the 10-day and 30-day moving averages, traders can refine their understanding of the current trend.
If the 10-day moving average is above the 30-day moving average, and the price is above the 200-day moving average, the trend is designated as “up.”
If the 10-day moving average is below the 30-day moving average, and the price is below the 200-day moving average, the trend is designated as “down.”
Step 2: Adding a Countertrend Indicator
There are many countertrend indicators to choose from, but for simplicity, we’ll use an oscillator based on short-term price action.
The oscillator is calculated as follows:
- A = 3-day moving average of closing prices
- B = 10-day moving average of closing prices
- Oscillator = (A – B)
When the oscillator is below zero, it indicates a pullback in price, and vice versa.
Step 3: Combine the Two Methods
By combining the trend-following and countertrend techniques, traders can look for instances when:
- The 10-day moving average is above the 30-day moving average.
- The latest close is above the 200-day moving average.
- Today’s oscillator is above yesterday’s oscillator.
- Yesterday’s oscillator was negative and below the oscillator value two days ago.
This scenario suggests that a pullback within a longer-term uptrend may have been completed, signaling that prices could move higher.
The Drawbacks
There are several caveats to this method.
First, this is not a guaranteed trading system but rather an example of combining two techniques to generate potential trading signals.
A responsible trader would need to thoroughly test any method before using it with real money.
In addition, traders need to consider other factors beyond just entry signals, including:
- How positions will be sized.
- What percentage of capital to risk.
- Where to place stop-loss orders.
- When to take profits.
Concluding Thoughts
While the method described here offers potential merit by combining trend-following and countertrend approaches, it is essential for traders to test and evaluate it before risking capital.
No strategy is foolproof, and many other factors must be considered to create a successful trading plan.
Nevertheless, combining these two techniques could help traders buy at more favorable times while still adhering to the dominant trend in the market.
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