How We Profit From Market Countertrends

When markets rallied from 2020 through 2021, traders focused so hard on the uptrend that many only went long.

Then rising inflation in 2022 tipped the market on its head. And many of those same traders completely flipped their view and only took on short positions.

But this kind of one-dimensional thinking is a real mistake for traders.

Because – as we’ve seen this year – most of the time, markets swing in between these two extremes.

While they might break out in one direction, they won’t go that way forever. It’s like a rubber band stretched too far. They’ll eventually revert to their mean.

And even in strongly trending markets, there are lots of countertrends along the way.

So, if you only view the market from one angle – bullish or bearish – you’re going to miss out on many trading opportunities.

Trends and Countertrends

When most folks get started with charts, the first thing they normally learn is how to identify a trend.

They look for a series of ascending or descending price points that they can join to form a straight line.

For example, take a look at this trends chart…

Spotting Basic Trends

Source: Fidelity

And once they spot these trends, investors often assume they’ll increase their odds of success by trading with – not against – the underlying trend.

Now, don’t get me wrong. Learning to identify trends (or lack thereof) is crucial when it comes to reading charts.

However, stocks (and the market) don’t move in straight lines. Even if they trend strongly, they’ll eventually snap back the other way.

Take a look at this graphic to see what I mean…

Source: Tradinformed

Many trading opportunities arise when a trend reaches mean reversion.

This is simply a byproduct of market dynamics as buyers and sellers constantly rebalance.

For example, if everyone is going long on a stock and its price keeps rising, eventually someone is going to want to take their profits off the table.

Then others will start to follow for fear of missing out on profits.

As selling momentum increases, it’ll eventually outweigh the buyers. That, in turn, sends the stock price lower.

Even in strongly trending markets, these moves against the major trend happen regularly.

And they can provide good profits if you’re ready to act quickly.

Putting Profit in Your Pocket

From a trading perspective, these countertrend moves offer many opportunities.

In fact, they’re a basic characteristic of market cycles that I’ve used throughout my trading career on Wall Street.

When the major indices got smashed in the Great Recession, my hedge fund was ready… and we profited handsomely from the inevitable bounce.

The good thing is that these rebounds – or “reversions to the mean” – happen whether the overall market is rising or falling. That’s because markets overshoot in both directions.

They also work in whatever time frame you’re trading… whether each tick on your screen represents a minute, an hour, or a week.

It’s a simple pattern – a move followed by a countermove – that constantly repeats. And this enables nimble traders to capture short, sharp moves that go against the major trend.

My followers profit from these kinds of trades frequently.

For example, earlier this year, Apple (AAPL) had a slight drop in earnings revenue and saw some bad news out of China. As a result, AAPL gapped down sharply. It lost about 10% in a week.

But we anticipated that this move had overstretched the stock to the downside.

This setup gave us the perfect chance to open a long position that would profit if AAPL recovered. And we made about a 36% profit in just a few days.

That shows the power of mean reversion trades.

If you add up all these kinds of profits over a year, you’ll be amazed how quickly your account will snowball.

But if you only stay fixed on the market’s direction, you’re going to miss out on a lot of this action.

Instead, you should park your biases at home and view the market simply in terms of repeatable patterns. Then you’ll be ready to jump onto more prospective moves.

And that’ll put more dollars in your pocket.

Have a happy Thanksgiving!

Larry Benedict
Editor, Trading With Larry Benedict