At its most basic level, a reversal strategy seeks to profit from market trend reversals. If the S&P 500 has been soaring for months and a trader notices a signal indicating a sell-off is imminent, the trader's objective is to profit from the bull trend reversal.
Typically, when a trend comes to an end, the market consolidates in a range for a period of time until a new trend begins.
At the end of an uptrend, the market often loses steam and volume, as well as making lower highs, before settling into a narrow range. Typically, it is only when this range is breached on the downside that we witness the true "reversal" that many traders seek.
What is a Trading Reversal Strategy?
When employing a reversal trading strategy, your objective is to profit from price reversals. One issue traders frequently confuse is whether they are trying to pick the market's top or bottom or whether they are looking for a trend to alter.
Trading reversals can be carried out within a trend, within a range, or against the trend.
For instance, if you're wanting to enter a reversal trade within a trend, you'd begin by identifying the broader trend. Price is clearly trending upward in the example below, with higher highs and lower lows.
To enter a reversal trade within this trend, we wait for the price to fall into a value or significant area. Typically, this is a support or resistance level. We then enter long trades from the swing low, waiting for price to reverse higher in the direction of the trend.
In the financial markets, reversals are a reality of life. Prices will inevitably reverse at some point and will see several reversals to the upside and fall over time. Ignoring reversals may result in a greater risk being taken than intended. When a reversal begins, it's difficult to determine whether it's a reversal or a pullback. Once it becomes clear that the price is reversing, it may have already moved a large distance, resulting in a significant loss or profit erosion for the trader.
How does the Reversal trading technique work?
To begin, you should wait for a big price movement: all candles will be the same color. Wait for 4-5 candles of this type to form. Naturally, you have two critical questions: will the trend continue, and when is the best time to buy an option?
Trading occurs in patches following price rollbacks. To see it on the chart, change the time frame from 15 to 5 minutes. False signals, on the other hand, are a fact. A reversal may occur by the use of an indicator or price movement, but the price instantly resumes its previous moving direction.
How can I purchase contracts using the Reversal strategy?
To begin, configure your trading terminal and then wait for the 15-minute timeframe's impulse movement. Switch to a lower timeframe as soon as multiple candles emerge on the chart (5 minutes).
CALL when the candles are heading upward and are over the Bollinger Bands. The price increased after bouncing off MA (10) in an upward direction. The MACD indicator is above zero;
PUT when the candles are trending downward and are below the Bollinger Bands. The price retraced its steps lower after bouncing off MA (10) in a bearish direction. The MACD indicator is trading below the zero line.
On the lower timeframe, the expiration term is set to three bars.
A reversal is a change in the direction of an asset's price trend. A pullback is a reversal of the trend, but it does not reverse it. Higher swing highs and lower swing lows define an uptrend. The higher lows are created by pullbacks. As a result, the uptrend does not reverse until the price strikes a lower bottom in the time frame being monitored by the trader. Always, reversals begin as prospective pullbacks. When it begins, it is unknown which one it will finally be. Traders attempt to exit positions aligned with the trend prior to a reversal, or they exit after they see the reversal has begun.
Intraday Trading Strategy for Reversals
Reversal trading is possible on all time frames, from the longer time frames such as the daily chart to the shorter time frames such as the 30 minute and 15 minute charts.
When trading reversals on intraday time frames, the idea is to use the major levels as a guide and to trade with, not against, any evident momentum.
If you've been trading for more than a week, you've undoubtedly already asked yourself multiple questions. How do you decide the precise time to enter? While other elements such as trade management, exit plans, and discipline all contribute significantly to your performance, selecting a suitable entry point increases your odds of executing a winning transaction.
Entry is key in every case. If you enter too soon, you risk entering at the worst possible time, when the trend has retraced and resumed its original path. On the other hand, if you join too late, you will miss most of the move and will have a harder time finding a solid risk:reward trade. Selecting an effective entry point is a skill that must be developed through experience, but there are entry tactics that make it easier.
1. Reduced Low and Increased High
The first entry approach is based on traditional chart analysis: uptrends have higher lows and higher highs, whereas downtrends have lower lows and lower highs. So what happens if an uptrend has a lower low or a downtrend has a higher high? Correct, there is a strong probability of a reversal occurring, and you should search for entries.
2. Disruption at the local level
As an extension of the prior notion of highs and lows, we will now examine how to trade a level's break. A level is defined in this article as a region where the price has previously seen repeated reactions. Levels can be defined by support and resistance, but also by supply and demand. The most significant amounts have been evaluated from both below and above. Finally, levels are not always a single price, but rather a zone within which the price is more likely to react.
At these levels, the price frequently reacts, frequently in the shape of a bounce or a move in the other direction.
Momentum is a key sign of whether the price will continue in the same direction. When a candle is significantly larger than the candles preceding it, we refer to it as a momentum candle. Often, momentum candles will close strongly, with little to no wick remaining.
4. Pinning and Driving
It has already been discussed the pin and drive reversal entry pattern, so it's only natural that it joins this list as well. Two concepts are combined in the pin and drive pattern: price rejection and momentum (see the previous strategy). The price rejection implies that, as the price level was being tested, it was violently pushed back down, generating the pin (bar). Following that is a momentum candle: a powerful push in the other direction.
5. Interrupt and Retest
Finally, we'll examine the break-and-retest pattern. Frequently, a break and retest pattern occurs in tandem with a reversal pattern. At some time, the price will reverse direction and enter a new trend (for example, by breaching a local support or resistance level), but just before this occurs, the price will retest the level it just broke. If the price remains in the initial direction following the retest, this is also an excellent indicator to enter a trade.
The five notions above illustrate five different ways to enter a reversal trade. There are more, but they should provide you with enough ideas to begin hunting for reversal scenarios on your own.
A very powerful reversal trade will frequently employ a combination of these entry tactics. For instance, the break of a local support level and the formation of a momentum candle. The more of these elements a setup contains, the more likely the trade will eventually work out.
Stop Loss For Reversal of Trend Strategy
A stop loss is used to manage risk. If shorting, the stop loss is positioned immediately above the top of the consolidation from which the short is entered. "Just above" is a bit ambiguous, but how far above the consolidation we position the stop loss will depend on the asset's volatility and the time frame on which we are trading.
When swing trading equities, the stop loss is normally set at least $0.05 above the consolidation level (for swing trading a forex pair, at least 5 pips). However, if the stock is more volatile or pricey, it may need to be placed $0.25, $0.50, or even a dollar higher.
Consider prior consolidations and if you notice the stock has wiggled out of prior consolidations by $0.15, $0.31, or $0.25 in the last few consolidations before eventually making a larger move, then set your stop loss $0.35 to $0.40 above the consolidation to provide sufficient breathing room for the trade. If you are day trading, you may position your stop loss $0.01 or 1 pip above the top of the consolidation, but you should adjust this based on what you see on the chart, as described previously.
If you are long, your stop loss should be positioned close below the bottom of the consolidation from which you are long. Once again, "slightly below" indicates that you must account for the asset's volatility in accordance with the principles above.
Anyone can enter a transaction; the skill is in exiting. Our stop loss enables us to manage our risk from the trade's inception. Because the technique does not always work, the stop loss ensures that we exit at a predetermined point if the price continues to move against us.
As a general rule, set your profit objective slightly above the prior low if you are short, and slightly below the prior high if you are long. This is a reasonable conservative aim that is almost certain to be hit.
Numerous transactions will halt and retrace their steps to the previous high/low. Numerous other trades will continue to move above or below that high or low. Regrettably, we cannot predict which scenario will occur. Thus, taking profit near the prior high/low is a prudent strategy.
Additionally, a trailing stop loss can be employed as an exit strategy.
The Reward MUST BE SUFFICIENT TO COMPENSATE FOR THE RISK
Before a trade signal develops and before any trade is entered, we already know our entry point (because the consolidation has formed and we know its high and low points), where our stop loss will be placed (outside the consolidation on the opposite side from our entry), and where our target will be (near the prior high/low). We can calculate our reward:risk (R:R) ratio using this information.
Assume you purchase a currency pair at a price of 0.7035. (just above the consolidation high).
You set a stop loss order at 0.6970. (just below the consolidation low). You now understand that your risk is 65 pips (or 0.0065).
You are aware of the previous high and set your aim just below it. You select 0.7420. As a result, your profit potential is 385 pips (0.7420-0.7035=0.0385).
With this information, it's clear that if the pattern holds true, you stand to profit significantly more from a winning transaction than you would from a losing trade. And that's a good thing, because if you make more money on winners than you lose on losses, the losers don't hurt nearly as much as the victories. Your R:R ratio is 385:65, or 5.92:1. If you wager $100, you will either lose it or earn $592. That is a reasonable trade-off.
And bear in mind that you will calculate this prior to entering the deal. R:R ratios of 4:1 or greater are extremely typical for this type of pattern. Avoid deals with a ratio of 2:1 or below.
The Most Pervasive Issue Observed in People
If you're not having success with the method, it's possible that you're overly concentrated on tiny waves. Reversals of minuscule waves have no meaning; they are simply noise. Tiny wave reversals do not "destroy the trend's vigor." Concentrate on the large waves (on whichever time frame you are trading), not the minute gyrations within them. Isolate the main waves and their reversals (even larger waves), and you will almost certainly discover that the method works effectively for you.
The Best Indicators for Trend Reversal
Averages that fluctuate
Moving averages are a widely utilized technical indicator across all markets.
Moving averages are utilized to smooth out the price action and provide insight into the market's direction. Additionally, they can assist you in determining the strength of a trend and if it is slowing or coming to an end.
When you trade with numerous moving averages, you can utilize them to identify trend reversals and reversal trades.
The MACD is another widely utilized indicator across all market types for recognizing fresh trends or momentum.
The MACD chart illustrates the information contained in two distinct moving averages and their interaction.
On your chart, the MACD appears as an oscillator and travels above and below zero. With this data, you can begin identifying emerging trends and determining when momentum is developing for potential reversal trade settings.
Simple Trading Strategy for Reversals
Utilizing the Fibonacci Sequence and Price Action
The Fibonacci tool is one of the simplest ways to identify high probability reversal trades across all of your different time frames.
The Fibo can assist you in determining when the price is likely to encounter support or resistance and may be on the verge of reversing.
The price is trending upward in the example below. After the price pulls back lower, we note that it enters the 50% Fibonacci retracement level.
At this retracement level, we might begin looking for long reversal trades in accordance with the trend higher.
Trading Fibonacci reversals
Reversal of Range From Critical Support and Resistance Levels
Range trading reversals is another approach that works well across all time frames. You can scalp with it if your trading style is better suited to shorter time frames or swing trade with it if your trading style is more suited to higher time frames.
Large-Cap vs. Low-Float Microcaps Reversals
Low-float momentum stocks, on the other hand, behave differently from their large-cap counterparts. It is not uncommon to witness a parabolic run-up followed by a corresponding sell-off. Let's be honest; the majority of runners played by low-float day traders are essentially pump and dumps.
Typically, rallies are triggered by a cleverly timed news release or promotion coinciding with the announcement of a capital raise or the conversion of a note to equity.
While this is not always the case, you should be suspicious of parabolic runs in microcaps.
Risk Management Suggestions
It's tempting to set your stop just above or just below an area of dispersion or accumulation. The issue is that these zones are imprecisely defined. Support and resistance levels are rarely exact points like $323.54, but rather an area around a level, the width of which varies according to the stock's volatility.
Consider Boeing, a mega-cap company. BA appears to be approaching a time of distribution, as the company's "composite operators" begin to sell their shares to the public.
Even a cursory glance reveals that the range exists, but it is far from clean. We anticipate a couple highs around the $360, $380, and even $400 range.
Reversals are some of the most difficult trading setups. They manifest themselves differently in each asset class and according to market mood.
While they have the potential to be extremely profitable, being incorrect in a reverse trade can be highly painful. Nobody wants to be on the receiving end of an aggressive trend.