Updated from its original posting on 04-11-2011
If you think that forex trends are overextended and that the market has reached a top or bottomed out, make sure you consider these points before taking a countertrend setup. After years of talking to my trader friends and other forex fanatics, I noticed a pattern that seems to pop up pretty often when talking about losing trades.
As it turns out, more and more traders are losing their trades and even getting their accounts blown up by trying to short at the “top” and going long at the “bottom.” In fact, while it may not be the number one cause of death of traders’ accounts, I can say that it’s still pretty high on the lists.
Take Dan F. Xavier, a young trader I met at a convention recently. He told me how he was so confident about buying EUR/USD at 1.1000 because he thought that the strong rally would end at that major technical level. His friends also bought similar pairs for the same reason. They ended up losing almost half of their accounts when euro weakness continued to dominate the markets for the next couple of weeks, even taking EUR/USD to the 1.0500 area.
Don’t get me wrong, I certainly understand the appeal of trying to pick tops and bottoms. The promising reward-to-risk ratios alone are too tempting, especially when the setup is supported by major technical levels.
Unfortunately, many traders pick tops and bottoms not for fundamental and technical reasons, but for the simple satisfaction of being right. But just because picking tops and bottoms present good reward-to-risk ratios it doesn’t mean that everyone should jump in at every opportunity. Here are three reasons why you should think twice before trading them:
1. More often than not, you’re not really looking at a top or bottom.
Ask any pro trader you know and he/she will tell you that picking a top or bottom is like catching a falling knife or standing in front of a speeding truck. Come to think of it, they usually end with the same bloody results (at least for your trading account).
A good explanation for this is that there’s a good chance that the technical levels that you’re looking at are not the ones the other traders are watching. Also, the other factors driving the trend (sentiment, fundamentals, etc.) might still be valid at a time when you think the pair is forming a top or bottom.
2. The subconscious need to be right from picking a top or bottom increases the danger of poor risk management.
Trying to predict a reversal can be tough, especially since you know in the back of your mind that you’re going against the current. In countertrend trading, it’s easier to mistake a retracement on the long-term time frame for a “reversal” on the shorter-term time frames.
Even more damaging is the misleading mindset that one can beat the market by pinpointing where exactly it will turn. This causes many traders to veer from their trading plans by placing tighter-than-usual stops and failing to let their profits run.
3. Countertrend trading takes experience
Although there are instances when both fundamental and technical analysis hint at a reversal, there will never be a guarantee where EXACTLY the market will turn. Not giving your trade enough breathing room for such potential reversals could be damaging to your account in the long run.
This is also probably why some seasoned traders caution against picking tops or bottoms. Taking countertrend trades demands a lot of market experience yet even some pros recommend that 90% of your trades should go with the trend.
With a lot of experience, and after doing your homework, picking tops and bottoms is just as good as any trading technique as long as you ALWAYS remember to practice proper risk management and give your trade enough leeway in case the market reverses a bit farther away from your predicted turning point.
Also, if you’re using a mechanical trading system designed to identify reversals, make sure to test the results on a demo account first or start out with small position sizes in live trading. Good luck!