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.

The Trend is not Your Friend

Boris Schlossberg

So there is so much to talk about this week. I could talk about how the SNB nearly destroyed the FX retail business in a matter of 24 hours. I can talk about how much fun I had in VT trading chat room where we banked so many pips that I stopped counting by end of week. I can talk about how I went from sheer elation after being on the right side of the EURCHF trade to complete panic when FXCM announced that they were basically staring into the abyss of bankruptcy to absolute relief when they found a White Knight just before the close of business on Friday.

But the most interesting thing to cross my desk this week was actually a throw away article on Marketwatch that revealed something fascinating about how money is actually made in the capital markets. In a piece titled Easy way to get rich: Buy the most hated stocks Brett Arends basically lays out the case for contrarian trading. Arends looks at 10 worst ranked stocks in the S&P 500 as named by Wall Street analysts and discovers that 100,000 invested into 10 most hated ideas every year since 2008 would have turned the portfolio into 270,000 dollars. Just investing into the broad S&P 500 you would have made 170,000 dollars.

That is a massive difference and I think it says a lot about how alpha is really generated. Don’t get me wrong. I am not arguing that the way to riches is just to blindly bet against the trend. That in fact is the way to ruin. And if you are a long term investor who really doesn’t have the time or inclination to follow the markets them the old and boring dollar cost averaging strategy of buying a fixed amount of index funds every single month come rain or shine is the absolutely best way to make your money grow. In the long run the trend does win.

But if you are a trader, the profit does not lie in the trend. Of course the obvious can sometimes be incredibly lucrative. Shorting oil as it continued to fall or selling EUR/USD as it broke 1.2000 were both great trend trades that made gobs of money. But the problem with those examples is that they are very much like lottery tickets -- incredibly seductive but utterly disappointing for 99.9% of us who try them. Just as the lottery trots out the winners and lets us vicariously wallow in their good fortune while conveniently forgetting about the millions of wasted tickets, so does the trading industry love to pull out massive multi-year charts of trend moves with very conveniently tagged labels -- if you entered here and exited here you would have made ten trillion percent!

But in reality how many people can really catch a trend? How many successful trend traders do you know? How many successful trend trades have you ever had .. IN A ROW? Yes of course you will catch an occasional big one and then most likely will spend the rest of the year giving back your profits in a series of endless retraces.

The truth of the matter is that the more I trade, the more I realize that the profit is in being in the minority. This is by no means easy to do, and it certainly doesn’t mean fading every rally or buying every dip, but it does mean that to make money consistently you need to be on the opposite side of the price because it is only at those extremes that you have a better than 50/50 chance of being right.

VT -- Making a Fortune 10 pips at a time

The VT day trading system that we use in the chat room proved that in spades this week. In the midst of some of the most vicious volatility that we’ve had in years, the rookie traders in my room managed to not only survive but to thrive by doing what was uncomfortable but ultimately profitable and the experience just served to convince me once and for all that the trend is not your friend.