Getting to know trend reversals and trading them
Among market players, there is a saying: "Trend is your friend". However, it is no secret that Forex in particular demonstrates a bullish/bearish trend for a third of all trading time only. But what do you do for the rest of the time, when the trend is reversing, or when is subsides so quickly that you have no time to identify and enter it? In these or many other cases, the skill of trading trend reversals might be of much help. However, to catch reversals with positive mathematical expectations, you need to work out clear criteria for identifying them. Fortunately, the strategy of trading reversals provides such criteria. It is applicable to timeframes from M1 to MN, on Forex, stock, and futures markets.
A signal to buy by the strategy of anticipated reversals
A signal to buy just a sequence of the following events to happen on the chart:
- a clearly detectable bottom must form;
- the price chart must confidently break through the trendline from below;
- the price chart must drop to the tip of the existing bottom, bouncing off the level where the first bottom ended. When the reversal bounce is over, you can detect by the formed local low whether you should trade long, if the price is still above the bearish trendline and the tip of the first bottom.
An example of a signal to buy:
As you see, under the bearish trendline, there formed a whole support/resistance area based on three bottoms, the middle one of which is breaking through the level of the other two ones, resembling a Head and Shoulders pattern. However, this scheme being reversal, the price pattern formed under the descending trendline, and we needed to wait for the other two conditions to be met before we started buying. And when the price broke through the trendline, bouncing off the set area, this could be interpreted as a full-scale reversal signal, authorizing bearish trade. By the way, please pay special attention to the signal bounce happening simultaneously off the previously broken trendline as off a support level. To make your trading especially efficient, you should be looking for such double bounces.
A signal to sell in Forex, futures, and stock markets
For a signal to sell in the form of a bearish reversal to appear, you need to look for a precise sequence of the following events - then your trading will most likely be profitable:
- a clearly visible top must appear, after which a quite deep correction is inevitably to follow; without both, other events are unlikely to happen;
- after the top forms, the price chart must step over the ascending trendline from above rather confidently;
- after the breakaway of the trendline, the price must rise to the top of the first top and bounce off the level lying there.
An example of a signal to sell:
In this example, the price again bounced off the set area and the ascending trendline, which also acts as a resistance level, and this reverses the trend, as reflected in picture two. Note that when the second reversing top was forming, a bounce off the level of the first peak lasted longer than off the trendline because a small consolidation formed right at the level of the first top. Also note that if such a thing happens to you, do not rush at playing short until the price gets to the tip of the first top and the trendline, if it is broken from below.
Stop Loss and Take Profit in trading reversals
Sure, Stop Losses are placed above the bounce-off top when selling and below the bounce-off bottom when buying. However, if the tip of the reversal bottom (as in the example of a signal to buy) is above the tip of the first bottom, you must insure your capital by placing an SL under the lowest of the bottoms. In the example of a bearish reversal, the situation did not repeat, but if your bounce-off top turns out to be lower than the first one, do place a Stop Loss above the highest of all tops.
Personally, I recommend placing a Take Profit when trading by this strategy. You never know how far the price will go even if you catch a reversal very luckily. Of course, you should trail the position by transferring the Stop Loss after newly emerging extremes. However, I do not think that this alone is enough because quite often, the price might go in the required direction after the reversal and then get stuck in a wide flat or reverse again - against you this time. Where to place a TP is up to you; practice shows that trading reversals can easily give a profit-to-risk ratio of 3-5 to 1. Of course, you can get into such a lengthy and calm trend that after trading a reversal with a fixed TP you will be lamenting your missed profit. Anyway, this is up to you: you either take your large profit more often or make small profits but be able to catch large trends.
Money management when trading reversals in Forex, futures, and stock markets
To those who prefer trading a fixed lot I say that this is a good method for this strategy because it means rather low tick risks. However, do not forger changing the lot siz3 depending on the size of your deposit, thus decreasing risks proportionally after losses and increasing them after profits.
But personally, I recommend risking a fixed percentage of the deposit, revised after each trade. I suppose that for trading reversals, this is more logical because such trade is risky as it is which means you have little chance to know in advance which entry will work and which one will not. Moreover, tick risks are not so small for trading a fixed lot to be more attractive than risking a share of the deposit. Note that in trading reversals you should not risk more than 2% of the deposit regardless of the money management method you choose.
To sum up, I want to add that when you scan the horizon for reversals, there happen plenty of hybrid situations when the price breaks through the trendline - and bounces off it and off some other level, even a support/resistance one, simultaneously bouncing off the trendline on the other side. Such cases can also be used for trading reversals but no more than once in one trading situation. If it does not work once, this means you can get mistaken many more times until a real reversal happens. Hence, try to use classical situation of this strategy as they give more chances for success.
By Dmitriy Gurkovskiy, Chief Analyst at RoboForex
