“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well, for twelve years I have been missing the meat in the middle, but I have made a lot of money at tops and bottoms.” – Paul Tudor Jones.
One thing I have observed is that retail traders can actually be quite good at picking market turning points. Consummate contrarians we tend to be.
You can see this by the preponderance of large orders at major key levels.
Where retail traders fall down is trade management.
If you want to be a contrarian, you need to hold on to your winners. Why? Because you are going to take some hits when you are trading against the trend in search of the turning point.
But classically, the retail trader lets their losses run and cuts their winners early—flip-flopping what they should be doing.
There is a better way… for those that have the nerve.
Where will the market turn?
We start by identifying areas where a major turning point might occur. Ideally, we will have an expectation of a fundamental trend.
Generally, it’s not a good idea to fight the price trend, so patience is required until we get to a key level or see a major basing pattern… otherwise the losses will be painful.
Look for these areas on weekly or monthly charts.
Rule #1: Identify major support or resistance levels on monthly and weekly charts
Rule #2: Identify a reversal pattern or “exhaustion move” on weekly or monthly charts.
There was plenty of warning on the monthly charts that we might be reversing on the EURUSD in 2014. Wait for these reversal signs off the level before stalking an entry.
Often the price will spike lower and recover very quickly near the end of a move.
Rule #3: Have a fundamental view that is in alignment with the trade (but be prepared to trade the price first).
Channel your inner Rocky
If you want to catch reversal moves, you need to learn to take the hits and keep on coming again and again.
Don’t be put off by a loss, and keep your position sizes small enough that you can take the hits and keep on bouncing back.
Don’t jump the gun
Once you have seen an exhaustion move or reversal pattern or the price has reached a key level, remain calm. Stalk your entry very carefully… and remember if you don’t get your entry, you can always use another system to capture the move.
Rule #4: Stalk a low risk entry point by waiting for a period of consolidation then breakout, or a candlestick reversal pattern on daily or weekly charts off the key level.
You can see how we get the eventual busted breakout below the key 100 level on the USDJPY.
It’s clearly visible on the weekly charts, too.
Focus on protecting what you have
“I’m always thinking about losing money as opposed to making money. Don’t focus on making money, focus on protecting what you have” – Paul Tudor Jones.
Once you have entered your position, your first task is to manage risk. Put your stop well out of the way.
Rule #5: Place your stop-loss 1% behind the low or high of your entry (it will normally end up 3-4% away). If the stop is more than 5% away, don’t take the trade. Wait for a better entry.
Build a bigger position
One “happy trait” of the market is that it tends to chop around before turning into a trend. You can learn more about this by studying market type changes.
We can use this sideways movement to build a position. To do this, we use the Bollinger Bands.
After we enter, we want to take a bit of profit (note this is not related to the rules below on taking profit—this is specifically for position building). This should be either on a fast MT stop or on the outer daily Bollinger Band (as relevant). We then look to add our position back on again when it reverses back to the opposite outer Bollinger Band.
When we add it back on again, we can use the profits from the trade we just placed to buy our original position back, plus a bit more.
You can do this multiple times, but each time you should take off a little less, as there is a greater chance of a breakout occurring the longer this goes on for. For example, the first time you might take 50% back, the next time you take 30% back, and then 15% back. The key is to never risk more than your original amount.
Once we breakout into a weekly bull/bear MT, we stop with the position building; it is only for around the entry.
This will allow you to, on occasion, build a larger position with small risk that can create a huge winner.
Rule #6: Scale in and out on the Bollinger Bands, adding to your position with each re-entry.
Note this is an optional rule, as it is a little advanced. You can also use this same approach to build a risk-free position by not adding any more to the trade when you re-enter.
Hitting home runs
We need a strategy for keeping with our winners, otherwise we will cut our profits short.
To do this, we exit in three parts.
The first exit takes a bit of profit off relatively fast.
Rule #7: Close 1/3 on either a weekly reversal pattern (like a hammer candle) or the daily Supertrend indicator (2,7).
The next bit comes off on a major reversal pattern.
Rule #8: Close 1/3 on a major reversal pattern
The final part needs to be kept on a very wide trailing stop for those big wins. For big wins, you have to be happy sitting through some large pullbacks.
Rule #9: Close the final part of the trade on the weekly Supertrend (3,7).
I am also a believer in having a final profit target to lock in gains.
Rule #10: Establish a profit target. Once the price comes within 1% of the target, employ a 1:1 risk/reward stop.
Nerves of steel
Being a contrarian can be a lucrative pastime.
But it’s not for everyone. You must be willing to roll with the punches and have the gumption to hold your trades though some pretty big swings.
Do you have the nerve?
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is the owner of www.fxrenew.com a provider of Forex signals from ex-bank and hedge fund traders (get a free trial). If you like Sam’s writing you can subscribe to his newsletter.