How To Use Technical Analysis the Right Way for Reversal Trading

Much of the popular literature in technical analysis deals with the variation between trends and intervals.

Traders and investors tend to follow the herd, good or bad, and whatever the dominant state of a market is, trend or range, traders tend to extrapolate into the future and expect to continue.

When these expectations are broken suddenly, we experience market volatility, which is exactly when prices change faster than usual.

When expectations are broken within a range, we call that a break. Everyone forgets about stock because it bounces between a small range of prices and does nothing.

Until news appears, or a large hedge fund accumulates a lot of stock, then it becomes apparent that the range has broken down, and everyone is rushing in immediately.

You can think of an explosion as a crowd rushing into a store at the opening of a Black Friday sale.

We’ve talked about explosive trading on this blog several times, but today we’re talking about reverse trade.

A trend reversal is when those expectations, which we talked about earlier, are broken within a market trend. Traders get used to the fact that stock stores, and they follow in the trend direction. Then when that trend breaks and the party is over, everyone rushes for the exits.

You can think of a trend reversal as the opposite of a breakout. Breakout is typically the birth of a new trend, while trend reversal ends a trend.

When you consider trends and ranges in this context, you can see that both bursts and trend reversals are just market surprises. And surprises on the stock market create volatility and uncertainty.

Traders who take advantage of these strategies aim to identify the circumstances where the crowd is stepping on one side of the market when a surprise is imminent, as these are the trades where they can achieve an extraordinary return in relation to their risk.

The real challenge, of course, is to find out when the market will surprise, losing the minimum when you make a mistake.

In this article we will review how applying technical analysis might help you notice trend reversals, as well as address some of the common mistakes made in this area.

Note on Trend Reversals

Before we spot a trend reversal, it is important to note a possible misunderstanding that some may have about trend reversals, i.e. that a new trend in the opposite direction is about to begin.

The popular phrase “trend reversal” is not entirely correct in this case.

Instead it looks more like the market is breathing down and entering a range before deciding where it will go next.

This is especially true in the stock market, which has more of a trend toward average reversal, while commodity and bond markets tend to have a stronger trend toward strong and long-term trends. These statistical trends are why traditional Turtle-style trend following models do not work in the stock market.

However, that doesn’t mean you can’t capitalize on trend reversals. All it means is that you may not want to bank on a completely new trend starting in the opposite direction, and instead play for the short-lived anti-trend movement.

The main idea behind this trading setup is that you take advantage of the short-term trend traders all cashing in at the same time as they realize the trend is weakening.

Sometimes you will arrive on a runaway train where a new trend is taking place in the opposite direction. These are great, but keep in mind that most of these settings take a few bars before traders get bored and the market is looking for balance, bouncing off without any visible trend.

Failure At Previous High

Most basic, a trend is a series of higher highs and higher lows (conversely for lower trends).

If we agree on this, we must agree that a trend is under suspicion, if not completely halted, when it fails to make a new high, or makes a lower high.

Below is an example of what a “under suspicion” trend might look like. At Swing C, the price has failed to penetrate the most recent high at Swing B. Immediately, the trend is suspected, and the following price bars will determine whether the trend will continue.

Remember, a trend is a series of higher highs and higher lows, and the maximum at Swing C is no higher maximum, so it no longer meets the technical definition of a trend.

This is an indication of the declining aggressiveness and willingness of traders to push up prices.

However, we have all seen those trends that experience momentary weakness at a recent high, falling into a short-term range close to the recent high, only to explode and continue with even more momentum than before.

This is what you might call a “complex retreat” to borrow a term from Adam Grimes.

Tiny details like these make trending trading more difficult than it might seem in theory.

That is why it is most important to pay attention to the character of the price action around the high. There is a significant difference between a doji candle right at the front maximum, and a large hammer candlestick at the front maximum.

The dividing factor here is price rejection.

When the market moves against the previous high with a lot of conviction. Below is an example of what we are referring to:

This is a situation where the market tells you that traders not only cannot set a new maximum, but that the market has firmly rejected even the previous maximum. It indicates that sellers are gaining ground and the trend is very likely to end.

Moment of Extinction (Momentary Divergence)

You can look at momentum as the rate of price change. “Impetus share” is a stock that rises rapidly (in percentage).

Trends live and die on momentum. In order to maintain a consistent pattern of higher highs and higher lows, there must be a continuous source of aggressive buyers willing to pay ever higher prices.

There are a hundred ways to quantify momentum, but most traders use one of several technical indicators such as MACD or ADX to measure momentum. No need to complicate things too much.

Here is an example of a neat stock trend that had problems when momentum began to decline.

The shares failed at a previous high twice in a row (marked by the red arrows) during decreasing momentum, as marked by the lower highs made on the modified MACD indicator:

Over-stretching

Every trader can identify an overstretched market. The stock price is growing at a rate that, if extrapolated into the future, would turn the stock into a trillion-dollar company in a year. It is obvious that the trend should slow down fairly soon.

However, if you’re even one or two bars too early, you could be sitting there with a massive loss.

Of course, you’ll set up a stop loss, but if the trend continues with a similar level of momentum, you’re likely to experience some slippage. Overnight trades are vulnerable to violent breaches through your stop.

All of this must be taken into account to play an inverse on an action that becomes parabolic.

One way to identify overly extended stocks is to use channels like Bollinger Bands or Keltner Channels.

When you have several consecutive bars where both the high and the low are completely outside the bands, and also the bar range is at least twice the middle range, that is an overly extended stock that will soon experience a volatile contraction.

These are parameters that you can easily punch into a screen if it is customizable enough.

Of course, you could always keep it simple and use an indicator like RSI to examine very high values ​​to find overly extended stocks.

The key thing with over-extended stocks is that you need a level at which you base your risk, and you need a market suggestion that there is potential for reversal, or at least weakness.

Most often this ‘suggestion’ is in the form of what I call ‘parabolic traffic’.

This is when several candles come together in the same area without any visible progress or decrease. There are usually large wicks that indicate market indecision.

Here is an example of this “parabolic traffic” to which I am referring, from a stock called Ideanomics (IDEX) in July 2020:

The Inland Trap

Many intraday trends see significant strength in the first hour of regular trading hours, only to slow down for the rest of the day, perhaps catching some steam again in the last half hour of trading.

It’s tempting to see this trend and start fading stocks in the afternoon, but the problem happens that so many of these trends don’t quite come out, and instead they just stop accumulating so much. So a considerable portion of your trades will be small gains or scratches, while many of them you will lose your full risk on the trade.

Of course, any trader trading any strategy will experience headaches.

The key is to do everything in your power to minimize these, so your expected value is above 1. Beyond reflecting on the issues in this article, review your trades, study literature on technical analysis and so on.

Bottom Line

Technical analysis books are covered by strategies for reverse trading. It is less important the specific arrangement you use, and more that you prudently apply sound business principles.

Business reversals are very risky and they are quite difficult for beginning traders to navigate.