Day Traders – Counter-Trend is Your “Friend”?!!!

Boris Schlossberg

The Trend is Your Friend. Trend Trading to Win. Don’t Fight the Trend. The trading business is littered with these sayings to the point where this view has become the conventional wisdom.

Try as I might I have never been very comfortable trading trend. I am always at my most relaxed when I am selling offers on a rally or making bids on a dip. I fully understand that this is much more a quirk of my personality rather than any special property of the markets, but lately, after watching all my counter algos perform markedly better than my trend ones, I’ve started to wonder if counter-trend trading is actually objectively better.

When I speak of trading, I mean day trading. My average trade hold time is 1 hour or less and on that time frame, the counter may just be better than the trend. One key reason is FX is a naturally bounded market. Unlike stocks which have a clear upward bias built into the instrument (the stock rises as the company grows), currency trading is range based by nature. Countries rarely go out of business (unless the are Argentina :)), so the ebb and flow between the major economies is always cyclical and always mean reverting. Most of the time, grand themes which are responsible for large trends, are absent which means that dealers will run levels back and forth, again favoring the counter-trend approach.

But there may be another, more technical reason for why counter trades are better on the ultra short-term time frame. Few retail traders know about the “last look” rule, but it is the fundamental part of the FX market. Matt Levine of Bloomberg, my all-time favorite financial journalist, explains it far better than I could, so I will just quote him here.

“I have a certain perverse fondness for ‘last look.’ The idea is that a market maker quotes a market on a thing—offering to buy it for $100.10 or sell it at $100.15—and if you come to her and say “yes okay I will buy it from you at $100.15,” she gets a brief chance to say “never mind.” If the price has moved against her in that brief delay—if now the thing is trading at $100.25 or whatever—then she doesn’t have to do the trade at $100.15. On the other hand, if the price has moved in her favor—if now it’s trading at $99.95—then she cheerfully executes your trade at $100.15. This is obviously good for the market maker; I once wrote:

It is as perfect an embodiment of “heads I win, tails you lose” as you could ask for: If the price moves against the customer, the bank wins; if the price moves against the bank, the bank decides not to play.

There are, I think, two things you can do with that model. One is, you can stop there, and say that last look is good for market makers and bad for their customers, that it’s a way for banks and other dealers to extract value from investors, and that it’s basically unfair and inefficient and should be banned.

The other is, you can assume that financial markets are fairly competitive and that in a market with last look—one where market makers have the opportunity to avoid adverse selection by getting away from trades that immediately move against them—the value that market makers extract from last look will be returned to investors in other ways. Specifically, it will be returned to investors in the form of tighter spreads. Perhaps in a market without last look the market maker would quote at $100.05/$100.20, knowing that if she sells at $100.20 there’s a good chance the market is going even higher. But in a market with last look she’ll quote at $100.10/$100.15, knowing that she’ll only sell at $100.15 if the market doesn’t seem to be going higher. So investors get to buy at $100.15 rather than $100.20, saving five cents. This benefit can be a little illusory—they only get to buy at $100.15 if the price is stable or going down—but it’s not nothing. If you want to buy a relatively small quantity of the thing in a relatively quiet market, tighter spreads with last look really should save you money.”

Now like it or hate it, last-look is a fact of life in FX and may even be coming to equities soon. But whether you think it’s a scam to bilk a few pips from traders or a necessary part of a fractured market that allows for ultra-tight spreads, it may explain some of the anomalies of why counter works better than trend. By its very design, last-look will generate inferior execution on trend trades which are flow-based by nature, as dealers will reject prices until the move has paused.

Before you get all conspiracy theory on me, understand that this is a rare occurrence. The FX market is highly competitive, most dealing tickets, especially the small retail sized ones, will be filled instantly. Yet at a time when you need liquidity most when prices are moving at their fastest in one direction or another, the prospect last look rejection rises markedly.

This, I believe explains some of the execution skews towards countertrend -- because after all if you are buying when everyone is selling, the market will be more than happy to fill you.

Again, these are differences at the margin, but in short-term trading where every fractional pip counts, the margin may actually be the edge.

If you are trading off the 4-hour or the daily chart, none of this wonky market structure discussion matters. In fact, you actually benefit from tighter spreads and the issue of trend vs, counter-trend becomes a matter your strategy and your personality. But if you are day trading with trend, you should at least be aware that the deck, if ever so slightly, may be stacked against you.