In one of my previous newsletters, we learned how we can use EMA lines to predict exhaustion and mean reversion in price. Basically, when a short-term EMA line and long-term EMA line are plotted on the chart, and form a bulge, there is a possibility of exhaustion and mean reversion. But does this mean we enter into a Contra-trend trade? Also, is trading contrary to the prevailing trend a good idea? In today’s newsletter, let us discuss what is Contra-trend trading, is it sustainable, and what are the challenges faced when trading against the trend?

Meaning of Contra-trend trading

Contra-trend trading means trading contrary to the trend. That is, trading against the prevailing trend. The idea of Contra-trend trading is to capture small gains when the price corrects or takes a pullback towards the moving average. One examples of Contra-trend trading is spotting RSI divergence when price is away from the average price and trading the short-term correction towards the average. Another example could be using an indicator to identify overbought or oversold zones and then entering into a Contra-trend trade etc. The basic idea behind Contra-trend trading is to spot exhaustion or probable short-term correction and trading that short-term correction.

Challenges while Contra-trend trading

While Contra-trend trading is a strategy used by many traders, there are challenges while trading this way:

1. Low probability: When a price move exhausts, the market typically corrects in one of two ways: price-wise or time-wise. A price-wise short-term correction occurs when the price declines toward the moving average. A time-wise short-term correction, on the other hand, involves sideways consolidation while the average gradually catches up to the price.

   The challenge lies in identifying which form of short-term correction will occur, as this is often uncertain at the moment of exhaustion.

2. Requires high level of certainty: In strong trends, price often enters overbought zones during uptrends or oversold zones during downtrends—and can remain there for an extended period due to sustained momentum. Attempting to trade against such trends requires a high degree of certainty that the entry point marks a probable top or bottom. Without that conviction, counter-trend trades carry a significantly higher risk.

3. Short-term corrections can be quick and short: When the market undergoes a price-wise short-term correction, the movement is often brief and sharp. In many cases, the price does not even reach the moving average before reversing and continuing in the direction of the prevailing trend.

4. Requires using leveraged products: Trading against a bullish trend typically involves taking short positions, which often require the use of leveraged instruments. While leverage can enhance returns, it also amplifies losses. As a result, losses incurred through leveraged short positions can be substantial in absolute terms compared to losses from unleveraged, cash-based trades.

5. Unfavorable momentum: Momentum in any stock or instrument typically aligns with the prevailing trend, as reflected by the price trading above or below the average. In contrast, contra-trend trading often works against this momentum, making it an inherently less favorable approach due to reduced probability and weaker price support.

Should you trade Contrary to the trend?

Trading against the trend is difficult to sustain over the long term. It demands a high level of conviction for relatively small rewards, which can be mentally exhausting. Moreover, designing a contra-trend strategy is challenging, as the patterns that appear before trend exhaustion are often inconsistent.

In contrast, trading with the trend is more forgiving. Even if the trader's analysis is not highly certain, the prevailing market direction and momentum work in their favor, increasing the probability of success. Also, trading in the direction of the trend gives more opportunities to trade.

Index trading: Trading contrary to the prevailing trend can be an option when trading indices but on an intraday basis. This ensures that the trader enters and exits the trade in the same day as well.

Outperforming v/s Underperforming stocks: Relatively outperforming stocks are ideal candidates for trading when the overall market is in an uptrend. Some traders consider shorting relatively underperforming stocks during broader market’s short-term corrections. However, even these underperformers may still be in an uptrend or consolidating, especially when the broader market remains above key moving averages.

The key insight is this: when there are abundant opportunities to trade in the direction of the prevailing trend, it is inefficient to focus on trades that demand greater effort, higher conviction, and carry increased risk.

If you want to trade both in the direction of the trend and during pullbacks, one effective approach is to use a smaller timeframe that aligns with the broader trend. The Nifty 50 index is well-suited for this, as it allows you to trade both trending and countertrend moves within a single instrument.

To simplify this process, I created a strategy called Stop and Reverse. It is designed to help traders capture both kinds of moves using the Nifty Futures contract. This strategy is explained in detail in a members-only webinar available on The Noiseless Trader platform.

You can access this webinar through the TNT One membership, which also includes recorded courses on charting methods, stock selection, classical theories, sentiment analysis, and weekly market sessions where I demonstrate how to apply these concepts.

If you are committed to learning trading in a structured way, I encourage you to explore TNT One using the link below 👇👇