If you’ve been reading our blog for a while, you’re probably familiar with our process and how we identify reward/risk scenarios that are ridiculously skewed in our favor. With that said, the way we accomplish that doesn’t always look exactly the same. Sometimes we’re buying breakouts and trading with the trend, other times we’re trading against the trend for mean reversion, and other times it’s some combination of strategies.
Below is a chart of Hindustan Construction which has been absolutely crushed year-to-date, losing roughly 80% of its value, but several signs have emerged to suggest the reward/risk is finally skewed in favor of the bulls. It’s a great real-time example of how we identify trade-able tops/bottoms.
Click on chart to enlarge view.
Let’s take a look at the points that are relevant from the chart above.
- Our downside price target has been met.
- Prices undercut that price target and quickly reversed.
- Momentum diverged positively as prices made a new low.
- Prices are very extended from their mean (200-day moving average).
- Quick follow-through confirmed the supply/demand imbalance.
- Short interest in the stock (not required, but amplifies move).
All of these characteristics combine to help create an entry where our risk is well-defined, probability of success is elevated, and reward/risk is skewed in our favor. We know going into it that counter-trend trades have a lower probability of success, but we’re willing to accept that when the reward relative to that risk is high enough (i.e. 10:1 or higher). That threshold is going to be different for every market participant based on their process.
From a practical standpoint, the way to execute the above example is to get long above 10.75 and target former support near 17. If prices get back below the former low, in this case 10.75, we cut our losses and move on.
Since the stock has confirmed its failed breakdown already and moved higher, the probability of success is greater, but it comes at the expense of a reduced reward/risk potential. With that in mind, waiting for a pullback toward our risk management level of 10.75 to obtain an entry with a higher reward/risk ratio is something worth considering if your process calls for a reward/risk potential higher than 2:1.
Nonetheless, it’s a valuable example for the future and provides you insight into the thought process that goes into our counter-trend trade analysis.
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Thanks for reading and please let us know if you have any questions.