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Trading Education Posted by Team Topstep October 3, 2022

How’s Your Fade Game?

Wrong Way Sign

Try this scenario on for size. Your favorite market is rising, and you feel bearish. You know prices are too high, so you try to short; however, your short gets stopped out. Ten minutes later, prices are even higher, and it feels that now is the time to short. But, once more, selling the market only means absorbing greater losses. By the third time, it’s a revenge trade with the same outcome. 

Let’s say you finally stop this behavior before using up all your trading capital. But then, the time you decide to abstain from shorting, the market turns and rolls over into the biggest fade ever.

Does this sound familiar? I’m pretty sure that this has happened to us all. I can recall around 2014 when U.S. equity markets were hitting all-time highs. Everyone had a chart, a trendline, an indicator, and an economic reason why the market was going to top out, but of course, it continued to ride higher. Some would BTFD, step in, and buy the dips for trend continuation, while others fought it the entire way up. 

Having been exposed to both the institutional (professional) world of trading and the retail industry, I can say that, generally speaking, less experienced traders, particularly on the retail side of things, are prone to looking for market tops and fading trends. Meanwhile, in the institutional world, professional traders tend to be less interested in this type of approach. 

One tangible example is found if you look at client positioning that some retail Forex brokers post; you can see that the bulk of clients are fading a trend. This can also be observed in other positioning reports, including the CFTC’s Commitment of Traders Report, which shows the positions of smaller traders. 

There Is No Wrong Answer

I can attest that trading with the trend is much easier than going against the market direction. Simultaneously, I don’t deny the appeal of counter-trend trading. I’m not here to convince you that fading the markets is right or wrong; ultimately, this is your decision. However, today I do want to give you some information to consider in the event that you are a market fader. 

For those of you who are unsuccessful at counter-trend trading, there may be some critical material here that will enable you to turn your trajectory. For those who are marginally successful at fading the markets, there may be key material that helps you go to the next level. 

Before We Begin – A Piece of Insight

There’s one thing to consider – you can fade the market and be a trend trader simultaneously. It’s merely a matter of perspective. For example, while the U.S. bull market was so strong for about eight years, the trend was clear. However, those rewarded bought pullbacks (and holding) in the upper trend. In other words, they faded a sell-off while still favoring the greater market direction. 

This is ideal if you are fading a short-term move but still remain with the trend. If there is direction on the daily chart, but you buy pullbacks on the hourly timeframe, then you are doing fine in principle. 

I knew a guy who ran a huge desk for a retail broker. He said 3/4ths of their clients traded against the grain, and 90%+ of those failed. The 1/4th who were successful faded retracements in an overall trend. This is something important to think about.

Risk to Reward is Critical!

The facts are, when you countertrend trade, you will be wrong more than you are correct. Sure, you can perhaps go on a winning streak, but having observed professional traders for nearly 20 years, I can confidently say that if you are a fader, you should prepare for more losses.  

This doesn’t have to be intimidating, as long as you plan for it. If you ignore the reality of it, you’ll be caught off guard. As you have heard me quote Sun Tzu before, “He who knows himself and the enemy need not fear the outcome of 1,000 battles.” If you know yourself and your market, then you can be prepared for the following 1,000 trades. 

The Most Important Metric

How do you compensate for having more losers than winners? Simply put, through your risk-to-reward profile. When a trader is risking 1 to earn 1, they need to be correct 60% of the time to barely turn a profit, given platform, data, and exchange fees. Therefore, countertrend trading at a 60% success clip is just unsustainable. 

If you are trading at a 3:1 return on risk, you must be correct on about 1/3 of your trades to be profitable. That is much more doable, even though it’s still challenging to depend on. 

However, if you are trading on a 10:1 return on risk, then countertrend trading suddenly becomes more appealing. Why? Because you’ve compensated for a higher rate of losses. You can be correct in 20% of your trades and still make a good profit.

Of course, the question rightfully becomes, is 10:1 even feasible? I’d say YES! Why? Because if you are catching a market at a top or bottom, and you grab it at the correct time, then you are catching a market at a new trend, so why wouldn’t you be able to target wider?

It always frustrates me to see traders who treat counter-trend trading as if it were a regular day trade and begin to take profit at the first glimpses of success. 

Instead, if you really caught the market at a shift, there should be ample room to ride it out!

So How Do We Make It Work?

The first key is to have a precise and programmed stop. Yes, sometimes it will be too tight, but that’s just the cost of business. What a programmed and precise stop accomplishes is that it will eliminate your compromises with risk. When risk is compromised, so are your account balance and your stability. 

Just think, if you are trading with tight stops, it is more feasible to target a 10:1 return on risk. 

So, where do we put the stop? Good question! I’d say make your criteria for entry so precise that as soon as your thesis has been exploited, you are out of the market – in other words, as soon as you are wrong!

When counter-trend trading, there is no room to give a losing trade space to work and make a rebound. Instead, it’s more like a burning building. Get out!

Secondly, make your target wide! Look for old highs and lows, don’t peel any of your position off until you’ve got at least halfway back there. Always leave a runner that will extend on a breakout beyond those highs and lows.

A Real Difference Maker

Do you really want to change your results? First, adding to losing trades may be beneficial when trading with the trend and if your position started smaller. However, when trading counter moves, never add to losers. 

Additionally, don’t take all your positions off at once. Instead, take profits in part as the market has established a new direction, as I mentioned above.

However, if you really want to make a difference, instead of peeling off positions, ADD TO YOUR WINNERS! For example, if you buy a lower market and believe the trend has changed course, look for previous highs as a target. Then, keep adding to your longs until the market arrives at the target. This way of compounding profits will turn a great trade into a difference maker. 

Be Picky!

If you are going to counter-trend trade, then some remaining good advice to consider is to use high scrutiny on your entries. If you want to increase your chances of success, be particular and wait for the stars to align. Sure, you may miss out on some good trades, but your fewer trades will likely give you better opportunities. 

Some examples of high scrutiny setups are waiting for price to be at key past levels and for your indicators to align; then looking for a bar formation that looks like a turnover in price or a sharp reversal; then entering when price starts to follow through – not merely when it looks like it could change, but when it is actually starting to change.

Beware of False Starts

When the offensive team is about to hike the ball in football, the linemen have to be very still. If they make a wrong move, they may be flagged for a ‘false start,’ meaning they moved before the ball moved. 

Trading counter-trends are the same way. There will be times when you think the ball is going to move, and it appears that the market will reverse, but it doesn’t. You must be prepared to endure this type of price action. The best way is to have a proven and back-tested strategy that gives you the confidence to maintain your plan. Furthermore, keep your losses small. This way, you will be less afraid to take your signals.

These are a few necessary things to consider when fading markets. Of course, this is not an exhaustive list. As I frequently assert, each of our personalities and styles is different, so it will be up to you to take the meat of the content and spit out the bones, adjusting these ideas to a way that suits you. Until next time, trade well!