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Tips on How to Trade With the Trend and Spot Reversals
Trend trading seems like it should be easy, but when you’re first learning about trends your trades will likely end up on the wrong side of a lot of them. This is usually a result of not fully understanding the nature of trends, and the common mistake of trading against the trend because you think a reversal is starting. Here I’ll show you a few tips that’ll help you understand the dynamics of trends and trend reversals, and how to get in on both.
Impulses and Corrections
Price doesn’t move in one sustained direction for long. Even during a strong trend, the price impulses strongly, then corrects, then impulses and so on. Therefore, during a trend there are two main environments that occur–impulses and corrections.
Impulses occur in the direction of the larger trend, and typically cover a large price area, even though the impulse doesn’t necessarily last long. These are very strong moves, and ultimately the ones we want be trading with.
Corrections on the other hand are movements against the trend. Corrections cover less price area than impulses. The smaller corrections allow for the price to make head way in one particular direction.
Impulses and corrections can both be either up or down. There is a misconception that corrections are always moves to the downside. This is not true. A correction is simply a move against the more dominant trend. So if the impulses–large price moves–are to the downside, then corrections will be to the upside.
Figure 1. AUD/USD – 15 Minute Chart with Impulses (Yellow) and Corrections (White)
Trading with the Trend
Ideally you want to trade in the direction of the impulses, and corrections provide you with the entry points. Two potential entry methods were covered in my articles Trading the “Mini-Channel Breakout” and Capitalizing on Lower Highs and Higher Lows in Price.
Sounds simple. If the large moves are to the upside, you wait for a correction and then use an entry method (such as the ones described in the aforementioned articles) to get in and ride the impulse to a profit.
But a trend, which consists of both impulses and corrections, won’t last forever. Eventually the impulses will begin to move in the opposite direction.
Figure 2. AUD/USD – 15 Minute Chart with Trend Change
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Spotting Potential Reversals
In order to trade with the trend, you also need to spot reversals. If you can’t spot reversals you will end trading with the old trend, and losing money.
Here are a couple ways to determine when a trend reversal may be occurring:
- An uptrend is created by higher swing highs in price, and higher swing lows. Therefore, if an uptrend fails to make a new high (creates a lower high), or creates a lower swing low, a reversal is potentially is underway. This doesn’t mean the uptrend is over, it simply means the uptrend is in question and therefore it is best not to trade until a new trend–either up or down–emerges.
A downtrend is created by lower swing lows in price, and lower swing highs. Therefore, if a downtrend fails to make a new low (creates a higher low), or creates a higher swing low, a reversal is potentially is underway. This doesn’t mean the downtrend is over, it simply means the downtrend is in question and therefore it is best not to trade until a new trend–either up or down–emerges.
- Watch the magnitude and direction of impulses. On the left half of figure 2 the impulses are down, in other words, the bigger moves are to the downside. On the right half of the chart, the moves to the upside are larger. Always ask yourself “In which direction are the moves larger?” When a shift occurs, as in figure 2, it signals a potential trend change. We always want to be on the side of the impulses, so trade in the direction of the biggest moves.
If you notice a market environment where both up and down moves are of similar magnitude, then you’re likely in a trading range or a choppy market environment because the price can’t make much progress one way or the other. I personally don’t trade during these times; I would much rather wait until a trend develops.
Most traders hear very early in their education that they should trade with the trend. Before that can happen though, you need to understand that price trends via impulses and corrections. Impulses and corrections both create a trend; it is simply the direction of the impulses which determines if the trend is up or down. In an uptrend watch for a lower high or lower low; in a downtrend watch for a higher low or higher high. These are both warning signs to avoid trend trading until a trend is re-established. Also, watch the magnitude of the impulses. When the larger moves start occurring in a different direction, a trend reversal is possibly underway. While it is not possible to know when every reversal will occur, or to always trade with the trend, avoid trading when the trend is in question and always try to trend trade in the direction of the largest moves (impulses).
Reversal Day Trading Strategies | Warrior Trading
What is a Reversal Day Trading Strategy?
At its simplest, a reversal strategy aims to profit from the reversal of trends in markets. If the S&P 500 has been rallying for months, and a trader spots a signal that a sell-off is coming, then they are aiming to profit from the reversal of that bull trend.
Most of the time, when a trend ends, the market ends up consolidating in a range for a period before a new trend begins.
At the end of an uptrend, you typically see a loss of steam and volume, as well as lower highs before the market settles into a tight range. It’s commonly after the downside break of this range that we see the actual “reversal” that many traders are looking for.
Here’s what most trend terminations look like:
I didn’t pull this theory out of a hat. It’s supported by not only one of the most respected technicians in history, Richard Wyckoff, but also has been validated through gigabytes (in .csv!) of extensive research by Adam Grimes. He didn’t just study S&P prices, he has tested his patterns on “Equities in the 1700-1800s, grain prices in Europe in the 1300s, and, perhaps to the point of absurdity, to the price of dates and barley in ancient Babylon!”
With that out of the way, this brings us to Richard Wyckoff and his concept of the Market Cycle.
Wyckoff’s market cycle has four stages: accumulation, markup, distribution, and markdown. See the graph below for a visual representation.
The premise behind the Wyckoff’s Market Cycle is that “smart money” manipulates the market so they can as early as possible and sell to the “dumb” retail money at just the right time. This ensures that retail is always holding the bag, and smart money captures the meat of the move.
At the core of this theory is that the market is that a few “Composite Operators,” highly informed traders and investors, almost completely control price and move the market at their will.
Accumulation is when the market is forming a base, supported by the quiet and careful buying of smart money.
On a price chart, accumulation looks like the market is trading in a range, mostly going nowhere. However, the Wyckoff practitioner can observe the subtle signals that smart money is buying.
Markup is when price breaks out of its accumulation range and enters an uptrend. According to Wyckoff, at this point, the composite operators have sufficiently accumulated their position. They are now ready to allow the market to auction higher, by essentially attracting the dumb money with a breakout.
Signs of a Reversal
In Wyckoff analysis, the two most crucial indicators are price and volume. While we may choose to apply others, these two should serve as our primary points of study.
The problem with identifying accumulation or distribution is distinguishing the difference between a random trading range and actual accumulation or distribution. One subtle sign Wyckoff analysts use are springs and upthrusts.
The Wyckoff Spring and Upthrust
Springs and upthrusts are the keys to distinguishing between a zone of accumulation/distribution and a random trading range. They occur when price momentarily trades outside of the range, only to be aggressively bought or sold back into the range.
In more modern jargon, you’ll hear a Wyckoff spring referred to as a failure test. The market is testing a break below the bottom of the range and is quickly rejected, indicating strong support.
Here’s an example from the S&P 500 in November 2008, a time when smart money actually was aggressively accumulating significant positions.
An upthrust is the same as a spring, except reversed. Instead of a failure test of the bottom range, it’s at the top range. In the same way that a spring may indicate a trend reversal to the upside, an upthrust may indicate a trend reversal to the downside.
Here’s an example of a successful upthrust and a failed spring pattern from Adam Grimes’ website:
Reversals: Large-Cap vs. Low-Float Microcaps
Low-float momentum stocks do move differently than their large-cap counterparts, though. It’s not uncommon to see a parabolic run-up soon followed by a congruent sell-off. Let’s be honest; most runners that low-float day traders play are basically pump and dumps.
There isn’t usually an underlying fundamental change in value driving the rallies, rather a strategically timed press release or promotion coinciding with the announcement of a capital raise or the conversion of a note into equity.
This isn’t always the case, of course, but you should be inherently skeptical of parabolic runs in microcaps.
Here’s a dramatic look at how compressed the trend reversals within a low-float stock can be. The trend both climaxed and wholly reversed in a week’s time.
In contrast, here’s a more typical example of a trend reversal. Observe how it took Apple about two months from the time of its trend climax, to the actual breakdown of distribution.
Graphs like the HMNY example above show how rampant speculation, manipulation, and FOMO are in the low-float market, as compared to the much more tame market of large-caps.
Indicators That Help Spot Reversals
I’m going to assume you’re trading a parabolic low-float stock, the stocks that most WT members prefer. For large-cap and assets that move slower, study the Wyckoff market cycle.
When trading reversals in parabolic stocks, I’m assuming that you’re trying to trade them from the short side. These stocks hardly go down exponentially, only to come back up days later, so the primary people tend to trade reversals on these stocks is on the short side. With that settled, let’s move forward.
A parable I trade by is that “momentum precedes price,” I’m not sure who was the first to say it, but it’s a core principle that I learned from Linda Raschke. It means that momentum, or the propensity of the market participants to move price aggressively in one direction, comes before the change in trend becomes apparent.
There’s many ways to identify a momentum divergence, but a straightforward technique is to exercise caution when price makes a new high, but a momentum oscillator like MACD doesn’t register a new high. Of course, this isn’t foolproof, but I’ve found it to be a simple way to spot a red flag quickly.
Here’s an example in a current runner, SNGX. The stock has shown lots of steam and has been running up all month. However, we see significant resistance around the $3.00 level, and the stock can’t seem to hold above the level for now. After a three-day sell-off, we can see that the stock caught a bid today (the time of this writing).
To many, this would seem like a sign that the stock may be preparing for another run, but there are a few warning signs that would either (a) stay out of the stock completely, or (b) look for short-selling setups.
The first red flag here is the low relative volume on the first green day after three previous bearish days. The stock failed to penetrate it’s declining 5-day volume average. The strongest leading stocks attract more volume when they’re advancing and less when they’re declining.
The next sign is an apparent loss of short-term momentum. As you can see on the 3-10 oscillator, which is just a modified MACD, the slow-line has flattened while the fast-line has lost its steam and crossed below the slow-line, a significant warning sign. We also didn’t see any action from the oscillator as a result of today’s semi-bullish market action.
From a Wyckoffian perspective, the stock could be entering a distribution zone as the smart money liquidates, leaving retail to hold the bag. In these microcap runners, the moves are so compressed, time-wise, that fewer data points are created, making it more difficult to identify each point in the cycle until after the fact. This could simply be a pullback in a continued uptrend or a top forming.
Of course, these technical signals are coming from the perspective of a short-term momentum trader. I have no idea where the stock is going. These are just reasons that indicate to me that the trend might be reversing and that alert me to be extra careful on the long side.
What We Look for in Reversals
Criteria for a reversal stock candidate
Tips for Managing Risk
It’s tempting to place your stop just above an area of distribution, or just below an area of accumulation. The problem is that these areas can only be roughly defined. Support and resistance levels are hardly at an exact point like $323.54, but more like an area around a level, with the wideness of that area depending on the volatility of the stock.
Let’s take an example in a mega-cap, Boeing. Below is a chart of Boeing (BA), illustrating what I’m talking about. BA is entering what looks like a period of distribution, where the “composite operators” are beginning to offload their shares onto the public.
Just by glancing at the chart, you can observe that the range is there, but it isn’t neat by any means. We see a few highs around $360, $380, and even $400.
A novice might see this chart and decide to place his stop at $401, just above what seems to be the point of resistance. See the next chart of Boeing below to see the typical fate of the trader who can’t grasp that support and resistance levels aren’t exact price points.
Admittedly, most traders who took sold Boeing short in the distribution zone before it’s run to $440 were stopped out, but that’s not the point. As you can see, each
Reversals are some of the trickiest setups to trade. They unfold differently in each asset class, and according to the current market sentiment.
While they can reward us hugely, being wrong in a reversal trade can be quite painful. Nobody likes being on the wrong side of an aggressive trend.
In my opinion, trading reversals is best suited for traders who have some experience, especially with reading the tape. And, as always, this strategy should be practiced in a simulator before risking real money!
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In a research paper published in 2020 titled “Do Day Traders Rationally Learn About Their Ability?”, professors from the University of California studied 3.7 billion trades from the Taiwan Stock Exchange between 1992-2006 and found that only 9.81% of day trading volume was generated by predictably profitable traders and that these predictably profitable traders constitute less than 3% of all day traders on an average day.
In a 2005 article published in the Journal of Applied Finance titled “The Profitability of Active Stock Traders” professors at the University of Oxford and the University College Dublin found that out of 1,146 brokerage accounts day trading the U.S. markets between March 8, 2000 and June 13, 2000, only 50% were profitable with an average net profit of $16,619.
In a 2003 article published in the Financial Analysts Journal titled “The Profitability of Day Traders”, professors at the University of Texas found that out of 334 brokerage accounts day trading the U.S. markets between February 1998 and October 1999, only 35% were profitable and only 14% generated profits in excess of than $10,000.
The range of results in these three studies exemplify the challenge of determining a definitive success rate for day traders. At a minimum, these studies indicate at least 50% of aspiring day traders will not be profitable. This reiterates that consistently making money trading stocks is not easy. Day Trading is a high risk activity and can result in the loss of your entire investment. Any trade or investment is at your own risk.
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Citations for Disclaimer
Barber, Brad & Lee, Yong-Ill & Liu, Yu-Jane & Odean, Terrance. (2020). Do Day Traders Rationally Learn About Their Ability?. SSRN Electronic Journal. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2535636
Garvey, Ryan and Murphy, Anthony, The Profitability of Active Stock Traders. Journal of Applied Finance , Vol. 15, No. 2, Fall/Winter 2005. Available at SSRN: https://ssrn.com/abstract=908615
Douglas J. Jordan & J. David Diltz (2003) The Profitability of Day Traders, Financial Analysts Journal, 59:6, 85-94, DOI: https://www.tandfonline.com/doi/abs/10.2469/faj.v59.n6.2578
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9 Tools That Trend Traders Can Use to Find Reversals
What is your trading strategy for finding the most reliable trend reversals?
As a trend trader, you want to position yourself along with the market trend. A trend reversal is both your entry and your exit.
This is why you must answer this question to the best of your ability. Focusing on finding the best reversals will put you on the path to trading success.
Conversely, each false reversal can cause you to miss potential trading setups. It will also have you scrambling to get back into the flow.
For a trend trader, the power of a multi-pronged approach is very real. With a set of varied tools, you can find reliable trend reversals with confirmation.
This brings us back to one important question: what are the best tools for a trend trader?
Like most traders, you probably have a general idea of how to find a reversal. For instance, you might rely on a moving average.
But, you don’t want to stop there. There are two other things that you need to do:
- Learn about different types of trading tools: price action, technical indicators, and volume tools.
- Appreciate the power of including a variety of tools in your trend analysis.
With that in mind, let’s review nine tools that you can combine to find the best trend reversals as a trend trader.
Price Action Tools
Price action is essential. It is a solid cornerstone of a technical trading strategy.
If price is reversing, nobody can argue with that.
#1: Swing Pivots
For examining price action, you need tools that are practical, simple, and useful. This is exactly what you get with swing pivots.
Open any chart and you will see that price does not move in a straight line. It moves in waves. The start and end points of these waves are swing pivots.
I’ll be the first to tell you that there are many ways to define a swing. At the same time, you should focus on one definition so that you don’t get bogged down with too many choices.
Once you’ve marked swing pivots on a chart, higher highs mean a bullish trend. Lower lows mean a bearish trend.
In this example, I’m using the swing definition taught in my price action trading course.
As you can see above, interpreting swings for reversals is not always clear-cut. But with experience, you can use price swings to find areas of potential reversals.
#2: Trend Lines
Trend lines are essential to a trend trader’s search for reversals. A trend line defines and tracks a trend.
The basic signal of a trend reversal is when price breaks a trend line.
However, false breaks are common. Hence, the key is the magnitude of the trend line break.
You can draw trend lines by connecting swing pivots. Again, there are many ways of drawing a trend line. But remember that your choice is less important than staying consistent.
Many traders learn by drawing trend lines ex-post on historical charts. It gives the impression that perfect trend lines are easy to find.
Don’t get into that trap. Instead, develop an objective method of drawing trend lines. Once that is done, you can draw them confidently in real-time.
The trend line in the example below is drawn using the method taught in my price action trading course.
Combining swing pivots with trend lines is a great trend trading method. The 1-2-3 reversal is a basic strategy that relies on swing pivots to define a trend reversal.
You can learn more about the 1-2-3 reversal in Trader Vic’s book.
#3: Price Channels
A price channel is formed by extending a parallel line from a trend line.
Most trends go through a channel phase. During that phase, price action bounces between the trend line and the parallel line. (The parallel line is also known as the channel line).
To find reversals with a trading channel, look for overshoots of the channel line.
Note that this approach anticipates a reversal. It is unlike the trend line strategy above which waits for a trend reversal to take place.
If you are an aggressive trend trader, this price action tool is for you.
A balanced approach is to start with watching for channel overshoots as a warning. Then, look out for a trend line break as confirmation.
While price action is useful, indicators can also help trend traders in finding reversals.
Technical indicators are also suitable for tracking a large set of instruments. You can easily set up clear criteria to scan for potential reversals.
#4: Moving Average
A trend trader can also find reversals with an intermediate to long-term moving average.
My preferred method of using a moving average is by observing its direction.
The strength of moving averages is that you can use a few of them to track trends of varying degrees.
However, apply too many moving averages and you’ll turn this strength into a drawback.
If you are just starting out, consider the 50-period moving average. For tracking shorter trends, you might want to use the 20-period moving average.
#5: Donchian Channel
This is the indicator used by the famous Turtles.
The original strategy’s profitability might have been eroded, but the Donchian Channel maintains its status as a powerful trend tracking tool.
In fact, the Donchian Channel is grounded with price action. It’s not your typical indicator with hard-to-grasp formula.
The Donchian Channel has two lines. They are the highest price and the lowest price attained within the lookback period.
This means that it is simply defining a price range using historical price action.
Let’s take a look at the Donchian Channel in action.
Refer to this free PDF for a detailed explanation of the Turtle trading approach.
#6: Moving Average Convergence Divergence (MACD)
As a trend strengthens, two moving averages of different periods will diverge. As a trend weakens, two moving averages will converge.
This is what Gerald Appel observed and used as the basis for the MACD indicator.
For trend traders, an impressive use of the MACD is for finding price divergences. A price divergence is a powerful reversal signal. It occurs when price and an oscillator disagree.
Technically, you can define a price divergence with two points. However, using three points like in the example above improves the quality of the setup.
Volume are important confirmation tools.
However, as they do not relate to price action directly, they tend to give early signals that might be less reliable.
Nonetheless, when used correctly, they give the trend trader a chance to enter the market before everyone else.
#7: On Balance Volume (OBV)
OBV is a cumulative indicator. It means that its value does not depend on a lookback period. It increases and decreases according to the polarity of each price bar.
The key implication is that you should ignore its values, and focus on its direction.
If both price and OBV are rising, the bullish trend is solid. Once the OBV starts to lose steam, a trend trader might sense danger. A reversal might be impending.
I like to observe the OBV through a long-term moving average of its values. A moving average helps to highlight the trend of the OBV, which is as important as the trend of the market.
In the example below, the background colour shows the slope of the OBV moving average. (green means up and red means down)
To learn more about trading with OBV, take a look at this article.
#8: Volume Oscillator
The Volume Oscillator is a handy tool but you must be careful. As it is based on volume, you must interpret it differently from price oscillators like MACD and RSI.
Positive values do not mean that bullish prices are supported. They mean that the trend, in either direction, is healthy. Negative values mean that the trend is weak.
With this knowledge, trend traders can also use divergences to find potential reversals.
Using the Volume Oscillator well is more challenging than applying price oscillators. Practise more and you will be well-rewarded with a volume perspective to price action.
#9: Volume Extremes
Extreme volume is a sign that the trend might have run its course.
In a rising trend, sudden extreme high volume might be the result of climatic buying. Climatic buying implies that all the buyers have bought. When there are no buyers left, the market can only go one way – down.
The same logic applies in a falling market. Climatic volume might have taken out all the sellers. Then, when there’s no more sellers, the market can only rise.
You can spot extreme high volume bars in retrospect easily. However, in real time, you might hesitate in deciding how high is high.
To solve this problem, you need a more objective method to determine if volume is high. One way is to use Bollinger Bands applied on volume data – orange line in the chart below.
Conclusion – Tools for Trend Traders
As a trend trader, you appreciate the importance of reliable reversal signals. But that’s only half the battle.
If you’re going to look for reversals, you should use an arsenal that includes both price and volume.
Also, don’t throw indicators out of the window. Instead, learn to use them prudently with price action as your beacon.
As you’ve learnt, some tools anticipate a reversal while other confirm a reversal. While no tool is flawless, you can use them to your advantage.
For instance, you can put on a small position based on the anticipation of a reversal. Then, increase to your full position once the reversal is confirmed.
Spotting reversals is one of the toughest but most rewarding trading approach. This is why a trend trader needs the best tools available.
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