Trade Against the Trend

Chapter 2: Why I do not follow the trend

Buy high and sell higher or sell low and buy lower. This is the mantra of trend followers. It sounds like common sense. Usually, that is what almost the entire trading industry recommends constantly. Reason enough to be skeptical.

The problem is, trend trading does not work for most traders. Now, you could blame me for trying to trade lows and highs at a mere guess. For who knows where the high or the low of the day or the week will be? Nobody.

That may be true. However, that is why switching to trend-following is just as much "guessing" for me. Because the assumption that the market will continue in the current trend direction, is just a guess. How could I know for sure?

For me, traders who want to follow the trend act subliminally even out of fear. They want to feel "safe" in the herd, because the herd follows the trend. It is always safer, or it feels safer when you go with the crowd, so, with the trend. Since the masses are on the safe path, and are afraid of being noticed, the results of this path are generally mediocre as well.

The best you can expect if you go this way, are moderate profits. That is why I say that if you want to among the winners on the stock market, you will have to look your fear in the eye. You will have to learn to walk a lonely path and you will surely have to learn to act against the majority of traders.

That is why I am a contrarian, a trader who acts against the trend. I am a trader who goes long when the whole world is short and vice versa. This is uncomfortable and certainly not for everyone. That is why it is important to understand why my countertrend method works. I would like to explain this in the next chapters.

Some traders may take my approach for granted. They should not. You would wonder how many traders buy or sell at points in the chart that are irrelevant. That is why I say: trade only when you feel afraid.

For people who are not used to trading, such an assertion could seem absurd. How can you risk money on the basis of fear! However, that is exactly what it is all about. If you only have a little experience on the stock market, you know that things are not rational here, as economists and analysts would like it to be. The stock market is often crazy. Almost every day, you can experience some kind of exaggeration. And that is exactly what real traders make their money with.

If the stock market were a rational entity (as the stock market engineers, as I call them, suggest), then there would be no reason to enter it. Because then every price that the charts indicate would be a rational price and justified by the so-called fundamental data. Then the market efficiency hypothesis would have won. The market efficiency hypothesis states that stock market prices reflect all the information available in that market. Everyone who has only a bit of trading experience knows that this is not the case.

However, the question is not: “How do you subdue this irrational thing called the stock market?” That is what the stock market engineers are trying to do. They design strategies based on back testing, that are spat out by their computer programs. There is nothing wrong with that. I have developed some myself, and I have written a nice little book about it. I know this way of thinking well and respect the traders who choose this way.

I wrote this book for traders who are more inclined to listen to their instincts. If you learn to listen to your gut, you can have the same success on the stock market as someone who calculates the whole thing and then runs it from a computer program. I would like to ask that the lady and gentleman engineers leave the room now. Those who I call the “crazy traders” can stay. These are the traders willing to do things the masses of traders never dare to do. In other words, from now on, we are going to talk about those trades where you get really scared. For as the Roman poet Plautus said: Abducet praedam, qui occurit prior.

(Latin: The early bird gets the worm)

Anyway, this book is not about penny stock trading and certainly not about illegal practices. Rather, I want to show the reader how to benefit from extreme movements as well, provided he overcomes his fear of doing the opposite of what the herd is doing.

For example, if a market runs to the north for seven hours, and there are the first signs that the buyers are running out of cash (losing momentum), then you can be sure that I am on the other side of the trade. I am short. And honestly, doing this is scary. Sometimes you might be a little bit scared, sometimes really scared. I am no exception. I am scared too. If the whole market is long, and you have a short position, then you really feel that you are alive.

Conversely, it is the same. If the market has fallen all day due to some event, and everyone is short, then you can assume that I am long. And this position scares me too. Me against the rest of the world. That is what this book is about: Me against the rest of the world.

I would not talk about these snapback trades if I did not believe there is a robust trading strategy behind this method. Otherwise, what I am sharing here would be worthless. I would like to make it clear again, that this method is not my invention, but has always been used by smart traders worldwide. Maybe you have not heard of it yet, because those people do not make a fuss about their business. These traders have internalized the method of taking the opposite position of extreme movements, so that they no longer have to think about it. They go short just when the mass of traders do not even dream of going short; if they go short at all (we know that only 1% of investors go short at all).

Most people just need some kind of "confirmation" that the market has turned and that they should now trade in the other direction. Some might say they need "a signal" to go long or short. There is an entire stock market industry that thrives on delivering such "signals" to inexperienced traders. If you intend to subscribe to such a "signal service", you will lose on the longer term. Believe me, I tried it several times in my early days and always fell on my nose.

Why? Because when the "signal" comes, the opportunity has already gone. Those signals usually come too late. Think about it: first, the analyst must recognize the signal on the chart. This happens when his indicators give him one. This is mostly when the market has already turned and has gone a bit the other way. Then the analyst (who, by the way, does not act on his own signals - he leaves this to the readers of his signal letter) goes to the computer and begins to write an exciting report, stating that his indicators have given him a significant signal. As a rule, some hours have already passed. If he then writes his report in the mailing list, and finally clicks on "send", several hours have passed before you get the mail. Depending on the size of the signal service, the readers start to buy and eventually, so do you. Think about it. Not everyone is at the start of the food chain.

The reader may already guess it. If you always wait for confirmation, the caravan will already have moved on. If you get into the market then, you usually get a much worse price than if you had bought, for example, when the market was completely down. That is self-explanatory, one should think. The old German stock market expert Andre Kostolany summarized it aptly: “You have to buy when blood flows in the streets.” Actually, this saying is the expression of common sense itself. The questions I ask are: “Why is it so hard for traders to put this stock market wisdom into practice? And why are many traders so scared to buy when blood flows in the streets? And why are so scared to go short when the rest of the world is long?”

The claim that I make in this book is simple, but very direct: if you do not experience fear when trading, then the position is probably not worth taking.

In other words, trade only when you are scared.

In figure 1, you see the example of a market that was stretched quite far. It literally crashed after it had shot up like a rocket, as if there were no limits. At least, that was what the optimistic crypto traders thought, dreaming of even higher prices.

This chart reminds me of the times of the dotcom bubble in 2000. Thousands of new "traders" also appeared out of nowhere, thinking that the laws of gravity had been rejected. Any experienced stock trader knows that it is only a matter of time before the house of cards collapses. That was the case after the dotcom bubble. It happened with the crypto-currencies, and it will always be like that where a market screws up, as if Newton’s laws suddenly no longer apply. This phenomenon is the topic of this book. I want to explore market situations that are just screaming for the rubber band to snap back.

Anyone who read my scalping books will recognize the setup. I am one of those traders who does not try to predict major market moves (a specialty of analysts). I cannot predict such movements as much as I would like, so I certainly do not try. What I can very well expect, is that after an extreme movement, I usually can expect a countermovement, a correction. My method builds on this logic.

There have always been traders who have been trading with the snapback method, or a variant of it. For example, some traders specialize in trading extreme moves in smaller stocks, so called penny stocks. Especially, if those traders are capable of going short in "overhyped" penny stocks.

Newsletter writers like to recommend certain penny stocks for their readers. They impress the readers of the letter with a very positive story about this small company. The readers call their broker and buy all the available stocks, which usually cost only a few cents on the stock market. That is why they are called penny stocks. Of course, it gets tight quickly in such a tiny “market”. Soon the readers will buy up the order book of this stock completely. The result is, the stock starts to rise massively. Price increases of 100 or 200% within two or three days are quite usual. Such an exaggeration inevitably brings snapback traders, who specialize in shorting such stocks, onto the scene. They try to build short positions the moment the momentum in the stock ends. Everybody has bought and is sitting on profits. The first ones are starting to take their profits, putting the stock under pressure. When the short sellers enter into the stock, more pressure comes in. Not infrequently, the stock crashes completely, often even deeper than where it was a few days earlier, when the stock was recommended by the newsletter. Needless to say, clever snapback traders are the ones who are making a decent profit here. Not the “readers – investors”. However, they have to be careful, because they may be wrong with their timing, and the stock might go up further for a while. If, in this case, the snapback trader does not take his losses quickly, he may experience a bigger loss.

There have always been scammers (quite often the publishers of those penny stock market bulletins themselves), who had previously bought the stocks before they recommended it in their stock market letter. When their "readers-investors" start to buy, they change suddenly to the seller side. That way, they benefit twice. No, three times. First, they make money with the subscriptions of their stock market letters (a profitable business!). Then they make money when the stock starts to rise. Finally, yet importantly, when the house of cards collapses, they often make money by building short positions. These people actually trade against their own readers of their stock market letters. Most of this happens through some straw men.

This practice is illegal. There have been spectacular condemnations in the past. Moreover, although everyone knows that regulators can identify this kind of fraud, surprisingly, there have always been individuals who have done it. If you want to know how it works and have some fun, all you need to do is watch the movie "The Wolf of Wall Street" with Leonardo DiCaprio. This movie shows how well this practice works. However, the film is set in the eighties, where the "dummies", so the “readers-investors” of the news bulletin, were lured on the phone. Of course, today it happens via email. But the principle has always remained the same.

Do any alternatives exist for times of low volatility? One of these is the snapback strategy. What is this? Everyone knows that if you stretch a rubber band, it will snap back eventually. In addition, the more you stretch the band, the stronger the backlash will be. This principle also applies to the stock market. That is why we speak of "snapback", that is, the band is snapping back after a movement has been stretched in an exaggerated way.

This method is based on the assumption that when a market makes an extreme move in one direction, one can assume that a backlash will follow. Although it is hard to anticipate the preceding movement, the trader can expect a counter movement, with a high probability. The snapback trader relies on this probability. He does not even try to guess if a market will make a big move up or down. He waits patiently. If he perceives such a movement, he positions himself in the opposite direction as soon as the preceding movement stutters or shows signs of weakness.

Fig. 1: Bitcoin, weekly chart 2016 – 2018

Chapter 1: Trade when the crowd is afraid

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms, and you make all your money by playing the trend in the middle. Well, for twelve years, I have been missing the meat in the middle, but I have made a lot of money at tops and bottoms.”

Paul Tudor Jones

Anyone who starts trading on the stock market should be fearless. I do not say callous, I say fearless. If you want to win as a trader, you have to be willing to take trades that hardly anybody dares to take. It has been like that forever. If you do the same thing as the rest of the herd, you get what the herd gets: almost nothing.

Therefore, if you want to do something crazy, like trading, then it should be worth it. Anyone who has read my scalping books knows that I am a countertrend trader. That means: I wait until a trend is exhausted and then take the opposite position. As a scalper, it just seems logical to me to try to trade the turning points that Paul Tudor Jones talks about in the quote.

This setup has convinced many scalpers. However, many, like me, have seen in recent years that it was not always easy to find markets where you could scalp well. The method works best in bear markets. I developed the method especially for such times.

In long-lasting bull markets, as has been the case since 2009 (as of November 2018), volatility will continue to dry up. So, it is getting harder and harder to find a market where you can scalp well, using this method. Therefore, many scalpers have begun to trade according to classic day trading methods. They trade on a 5-minute or even a 15-minute chart. Others have started using my method on higher timeframes. Of course, it also works there, because it is based on the universal principle: the best opportunities are at the turning points.

Part 1: The Snapback Trading Strategy

Table of Contents

Part 1: The Snapback Trading Strategy

Chapter 1: Trade when the crowd is afraid

Chapter 2: Why I do not follow the trend

Chapter 3: Mean Reversion

Chapter 4: Risk Management

Chapter 5: How do I recognize extreme movements?

Chapter 6: Patience at the entry

Chapter 7: Does the Stop really protect me from heavy losses?

Chapter 8: Trade Management

Chapter 9: Exit

Chapter 10: When do the best trading opportunities occur?

Chapter 11: Why you should study the economic calendar

Chapter 12: Which markets are suitable for the snapback strategy?

Part 2: Trading Examples

Chapter 1: Examples in the Stock Indices

Chapter 2. Examples in the Currency Markets (Forex)

Chapter 3: Examples in the stock markets

Chapter 4. Examples in the commodity markets

Glossary

Other Books by Heikin Ashi Trader

About the Author

Imprint

Trade Against the Trend!

Heikin Ashi Trader

DAO PRESS

(Latin: The early bird gets the worm)