The Psychology of Reversal Trading - 8 Steps for Improvement - Part 2

Yesterday we looked at some of the challenges of counter-trend trading and the first four rules that you may use when trying to trade tops and bottoms. Today, we continue this series, beginning by drawing from the wisdom of an ancient Chinese warrior.

Sun Tzu says: “If you know the enemy and know yourself, you need not fear the result of a hundred battles.” I like to apply this to trading, if we traders the markets we trade, and ourselves, including strengths, weaknesses including psychological barriers, then we can account for such and enter trades with confidence.

However, for traders who wish to counter-trend trade, this too often leads to the ruin of trading capital. One of the reasons is simple, that if you are going against the trend, you are going to be wrong more than correct. I have been around many traders who are successful both in the retail and professional industry and can tell you this as a broad-based experience.

Sure, anyone can have hot streaks; however, the test of time is what the downside is during cold streaks, and even the best counter-trend traders experience hard times. My purpose is not to discourage traders from attempting to spot tops and bottoms, as I have noted that this is psychologically unavoidable for many, but instead to call attention to responsible skills of reversal management.

Every trader has likely experienced this everyday moment in the life of a trader. The market is declining, you have reason to buy, however, after going long, the trend continues lower, and you are stopped out. This experience may happen a second and third time. By the fourth signal, the set up is perfect, but you are afraid, your confidence is depleted, your mental capital is drained, and your financial equity has reached a limit. You talk yourself out of buying the fourth time, and that is when the market reverses higher and with great momentum and intensity retraces its steps.

Meanwhile, you are on the sidelines frozen asking yourself why you didn’t buy the fourth time, or why you didn’t just short during the downtrend to begin with. That experience is sad but often typical. Today, we will look at some ways to counter-trend trade with confidence and a clearer mind.

I’ve already noted to be self-aware, that is key. To know yourself, why you are distrusting the trend, and why the market has reason to agree with you. Secondly, let’s assume you accept the fact you will lose more times than you will win on counter-trend trading. There are still ways to make this work. Below are rules 5-8 that I have developed over the last 12 years for counter-trend trading.

1. Don’t Exit At Once: This is for winners, scale-out of the position, this will allow runners to reach those broader objectives.
2. Know What Time It is: Remember Sun Tzu, you must know your market and how it behaves at various times, and the better times of day for trading a reversal. Also, you must know your internal clock, and when you make the most accurate decisions in a day.
3. Listen To Your Emotions: The reason why algorithmic trading trumps humans is that they trade without emotion. Humans are incapable of being emotionless. Rather than ignore your emotions, pay attention to your thoughts, feelings, heartbeat, and breathing patterns, and know when you are trading based on emotion or logic.
4. Learn to Forgive: This includes yourself. Revenge trading is the easiest and most painful way to lose money. When you are wrong, forgive yourself rather than trying to validate yourself.

For rules 1-4, please see here. You may choose to implement these rules as you wish. What is important is that traders do have guidelines and stick to them. I often encourage my colleagues to print out their own rules and keep them nearby to reinforce them throughout the trading days.