The Psychology of Reversal Trading - 8 Steps for Improvement - Part 1

In the zero-sum game of financial markets, smaller traders look for opportunities to level the playing field. There is a long time saying that every trader will hear numerous times during their career that “the trend is your friend.” As accurate as this statement can be, the reality is that there are left brain and right brain traders. Some prefer nothing more than to look for opportunities to engage an existing trend. However, numerous traders have a psychological block when it comes to buying a market in the current trend.

Take, for example, traders who utilize the various forms of the U.S. equity index markets like the S&P 500, and it’s derivatives. This market has been trending higher for years, with every sell-off an opportunity to buy. However, analytic tools such as the CFTC’s Commitment of Traders Report as well as broker sentiment tools for CFD’s (contracts for difference) have consistently reflected a retail trading market that overwhelmingly tries to short the S&P 500.

Whether it is because you are naturally a contrarian or feel the mental freeze of trend following, these are real psychological variables that traders must face. The intent of this article isn’t to shame traders, but first to encourage you to call attention to your own subconscious bias. Self-awareness is healthy in all areas of life, and for a trader to perfect his or her craft, then self-awareness is an absolute necessity.

To help compensate for the challenges of counter-trend trading, below are the first 4 rules that I have developed over the last 12 years of trading.

1. Aim Small Miss Small: Use less capital on counter-trend trades. That way, you can take multiple attempts, and when you are right, then you have the opportunity to make money on the reversal momentum regardless.
2. Thread a Needle: Use a tight stop when trying to target a top or bottom. Be precise in your entries, and know where your bias fails. 
3. The Retest: Remember that while there are V-shaped reversals, the retest (W type) rebounds often give very reliable signals.
4. Hold Your Winners Longer: This is key, if you nailed a bottom or top, then the reversal is going to pay. One problem is that because reversal trading has a lower winning percentage, traders take profits too soon. However, because of the nature of this style, traders may use a 5:1 return on risk ratio or greater even.

I encourage all traders that when they identify their own rules, write them down and tape them to their monitors to continually remind them during the trading day. Tomorrow, we will examine 4 additional counter-trend rules to enhance your arsenal. 

[Part 2 is now live! You can check it out here]