With-trend trading vs. Counter-trend trading for Binary Options

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With-trend trading vs. Counter-trend trading for Binary Options

One of the biggest questions binary options traders ask is whether they should always trade in the direction of the dominant side of the market, or if counter- trend trading is also an alternative.

The answer is that both can be effective and this article will focus on the advantages both alternatives can have and when you should them when trading binary options instruments.

With-trend binary options trading

Highly effective, especially if the market has a well determined directional bias. The big advantage of this is you are putting the money where most of the market participants are also, so the probability of ending up with profits is higher. Since you are trading binary options, by going with the “flow”, you are most likely to hit a winner, as the price can end up higher when you place a call option in an uptrend, or it can end up lower, if you place a put option. Also, the time frame is very important. If the trend had been going for several days in a row, placing a longer term option can help avoid price corrections that might intervene. If you want to place a short-term binary options, placing it around strong support/resistance levels can be highly effective.

Counter-trend binary options trading

Most of the time you should be trading with trend, but as you know, the market will turn at some point in time and the trend will reverse. Counter-trend trading is very effective when you spot that the market is very likely to reverse or, if you spot a strong support/resistance area in front of the trend, where the counter-trend players might see an opportunity to get in.

Also, news trading, when it comes to headlines that don’t support the overall trend in the market, could represent another opportunity for counter-trend binary options trading.

Risk Warning and Disclaimer

Trading binary options on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in binary options you should carefully consider your investment objectives, level of experience, and risk appetite. No information or opinion contained on this site should be taken as a solicitation or offer to buy or sell any currency, equity or other financial instruments or services. Past performance is no indication or guarantee of future performance.

Market News

When looking at a chart most traders can identify the current trend. Although this is easier in some cases than in others, this is not the most challenging aspect of trading. The difficulties start occurring when creating a plan of action.

Beginners often think countering the trend is the best way to proceed, as they attempt to catch the entire movement. “It has already gone too high”, “The previous equilibrium will be restored” and so on are phrases which you will often hear, if asking why they think countering is the best course of action. They all come from hearing the old saying “Buy low, sell high”. Though it makes sense, determining which price levels are highs and lows is the tough part. We are not saying counter trend trading doesn’t work, but most traders find it way more tricky, than following the major moves. We will compare the two approaches to trading in a generalized manner:

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The set-ups

First of all, the way traders determine their precise market entries, with both methods is different. Trend following systems may involve a breakout of consolidation. Technical price patterns, like triangles, wedges, flags and so on, often times prove useful. Additionally, traders often enter the market, at places where they believe a retracement to the major move has ended. This is a bit more difficult to judge, as properly distinguishing a correction from a full-blown market turnaround is tough. Some traders prefer entering at Fibonacci retracement levels, while others focus on trend lines. Here is an example:

Although this is not an ideal example, as the new lows are not substantially lower than the previous ones, we can still illustrate the point. Many traders will opt to go short at points A and especially B. Others may wait for the point where the price is currently, before entering, but this will be a bit too late.

Counter-trend strategies involve a way of determining a potential market turning point. Formations, involving a few candlesticks are often used as the first indication. There are many variations of the these bars: pin bars, kangaroo tails and so on. The essence is that you see a candle, which has a long wick in the direction of the dominant trend. The close should be Here is an example:

The presumption is that the buyers, if we are talking about a bullish trend, have pushed the price higher, but have been overpowered by the end of the period. These candles have more strength, if they occur at major support and resistance levels. They must be followed up by several other bears, following the counter momentum. Many traders also apply additional filters, like their favorite oscillator, MACD or something of that nature.

Stop-loss and take-profit targets

One of the biggest weaknesses of trend following strategies is the fact it is often hard to determine your stop-loss and target levels. As far as targets go, simply moving your stop, after the market moves in your favor is probably a reasonable strategy.

The easiest approach is to place them on the other side of the nearest market swing against the trend. The question then becomes, which moves should be considered as swings. While experienced traders can make these judgements with a naked eye, beginners may find the Zig-zag technical indicator (which is available in Meta Trader 4) helpful. Other methods include using the Fibonacci retracement tool or Pivot Points.

Here is an illustration. Let’s say you were short from a point before the beginning of this chart.

Had you moved your stop in the zone around point A, when the consolidation formed, you would have been stopped out way to early. Sharp corrections, like the one which occurred at point B are often better places to move your stop to, as they indicate a rapid change in the minds of market participants, rather than a consensus (as indicated by a consolidation). Although point C may appear to be similar to A, it has approximately three times as many candles, making the resistance above it much better established.

The initial stop-loss order in a trend-following strategy is a bit easier to determine. As long as you have a decent risk to reward ratio, even a wider stop can be applied.

On the other hand, counter-trend trading usually provides much closer (and easier to define) stop-loss levels. Usually they are a several pips away from the market extreme, formed by the initial candle, which signified the potential turning point. If you know the basic principles of risk management you may be thinking this implies you can take a much larger position. Though this is true, we would advice not overdoing it. Counter-trend traders often get it wrong – the market continues, they get out and await the next opportunity.

Determining your profit target, when countering a trend is much harder. It often depends on the nature of the trend itself and your risk appetite. If a trend has progressed quickly, it is more likely to reverse just as fast. A slow and steady tend may transform into a sideways market. A contrarian trade can eventually turn into a trend following trade, in the opposite direction. However do not get carried away and have some exit strategy.

Adding to a position

Adding to an already existing position is recommended mostly for trend following strategies. This strategy is called averaging up, and is often recommend. In essence you start to risk more, after the market has at least partially proven you right. Here is an example to illustrate this point:

You are long ERU/USD, with 1 standard lot from 1.0500, expecting it to go to 1.1200. It reaches 1.0700 and then you:

A) do nothing. The marker moves in your favor. You net a 700 pip profit, with 1 lot (+$7000);

B) you add another lot to your position. Now you have a net position of 2 lots from an average price of 1.0600. Your result will be 600 pips, with 2 lots (+$12,000) if the market were to go to its destination.

Averaging up obviously comes with adjustments you have to do to your risk management. Were you to put a tighter stop, you may be shaken-out of the marker way to early.

When it comes to counter-trend trading, you essentially have the ability to perform the same procedure, as the one described above, if you are waiting for a big-enough move. The real problem comes, if your initial prediction turns out to be wrong and you decide to move your stop-loss further away or even add to your position as it is moving against you. The latter is called averaging down. The same principles, involved with averaging up apply and you probably realize how dangerous such trading can be. While this can work out occasionally, it takes one big loss to wipe out months’ worth of gains.

As the legendary trader Jesse Livermore put it: “It is foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let this thought be written indelibly upon your mind.”

Conclusion

Trend-following and counter trend strategies can both be profitable. That being said, calling market tops and bottoms is a lot harder than catching a piece of an established trend. Contrarian strategies can get less experienced traders in trouble quickly. On the other hands veterans love them due to the high risk to reward ratios which they provide. This is yet another trading dilemma which doesn’t have a clear answer, like the one regarding automated trading vs manual trading. Hopefully we provided you with some food for thought.

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