Reversal Patterns – Combine Reversal Indicators To Spot Trade

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Reversal Patterns

Reversal patterns and technical indicators are two great tools for finding profitable trading opportunities. Combined, they unlock their full potential. This article explains how you can use technical indicators to make the most of your reversal pattern trading with binary options.

  • What Are Reversal Patterns?
  • Combining Reversal Patterns And Technical Indicators
  • How To Trade Reversal Patterns

With this information, you will be able to use technical indicators to support your reversal pattern trading with binary options.

What Are Reversal Patterns?

As the name indicates, reversal patterns are significant price formations that indicate an impending market reversal. The right technical indicators can aid you in trading reversal patterns, unlocking many more trading opportunities for each reversal pattern and helping you to better trade the more well-known opportunities.

There are three main reversal patterns you have to know:

1. The Head And Shoulders Formation

The market is in a trend and reverses. The head and shoulder can both represent an ending uptrend and a beginning downtrend or an ending downtrend and a beginning uptrend. In the picture, you see the top reversal with an ending uptrend. For the bottom reversal, just flip the picture on its head.

2. The Triple Top And The Triple Bottom

The triple top or bottom is a head and shoulders formation with two shoulders that are closer to the extreme. In the picture, you see a triple bottom that indicates and ending downtrend and a beginning uptrend. The triple top is the same thing flipped on the head.

3. The Double Top And The Double Bottom

The double bottom and the double top look very similar to the triple bottom and the triple top. The main difference is that the market forms only two bottoms/tops, and reverses only once between those bottoms.

The beginning of the double top/bottom is the same as with the triple formations. The market creates an extreme and reverses briefly. After that, the patterns are slightly different.

  • In a double top/bottom, the market takes longer to form the second bottom. The movement there is erratic and often shows a significantly lower volume. You can see this difference in the picture, where the market seems to stutter its way to the second bottom.
  • In a triple top/bottom, the movement to the second extreme is straighter. While its volume is already lower than during the preceding trend, it is higher than in a double formation.

Often, the movement to the second extreme helps you distinguish between the double and the triple formations. We will soon analyse how technical indicators can help you with this important task.

The double formation completes when the market breaks through the price level of the previous reversal. At this point, a new trend will likely start in the direction of the preceding trend.

Combining Reversal Patterns With Technical Indicators

As you can see with the double formations and the triple formations, reversal patterns are often difficult to distinguish by pattern analysis alone. Only when they are complete, it is easy to see which reversal pattern you are dealing with. Technical indicators can help you to earlier recognize reversal patterns and more accurately define their boundaries

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Put yourself in the shoes of a reversal pattern trader. When you think that the market will reverse, there are still many questions to answer. Questions such as:

  • Which reversal will the market form?
  • Will the market reverse after two highs/lows or will it create three high/lows?
  • Will the market form a large reversal pattern or will the pattern be smaller and quicker?

Answering these questions is essential to winning a trade.

  • When you think that the market is forming a double bottom, but it is really forming a triple bottom, you might invest too early.
  • When you think that the market is forming a triple bottom, but it is really forming a double bottom, you might invest too late.
  • When you think that the market is forming a triple top, but it is really forming a head and shoulders top, you will make all sorts of wrong predictions.

Accurately assessing the current market environment is essential to making the right predictions. Technical indicators are the ideal tool for this job. They can do three things for you:

  1. Technical indicators can help you understand when reversal patterns will form. Leading technical indicators help you understand when a trend is running out of momentum. In these market environments, a reversal will happen soon, which is why you know that you have to search for a reversal pattern. When you see the first signs of a reversal pattern, you know what is going on and can make the right investment decisions. Without technical indicators, you would be late to the party and miss out on great trading opportunities while maybe making bad decisions.
  2. Technical indicators can help you to find more trading opportunities in a reversal pattern. Understanding reversal patterns will help you recognize the general pattern. But this rough outline is insufficient for making an actual trade. When you know that the market is going through a reversal pattern, technical indicators help you understand how long each movement in this pattern will last. Therefore, you can determine the reach of each swing and trade all kinds of binary options based on this indication.
  3. Technical indicators can help you understand which reversal pattern you are dealing with. When you understand how far a swing will reach and when it will turn around, you can more easily distinguish the different forms of reversal patterns. When the market is nearing its second high during a bottom reversal, technical indicators can predict whether it will turn around soon and form a triple pattern or continue to rise and form a double bottom. You know what to expect and you can make better trades.

Combined, these three advantages provide you with a much better understanding of reversal patterns. By adding technical indicators, you can significantly improve your accuracy, your timing, and the number of trading opportunities that you find.

These advantages are so significant that every trader should consider adding at least one technical indicator to their trading of reversal patterns. Let’s take a look at how you can do that and which technical indicators can help you in which ways.

How To Trade Reversal Patterns

At this point, it is time to get concrete. We will now outline a few strategies for how to combine reversal patterns and technical indicators. The important point of these strategies is to show you the possibilities and the tools you can use. You do not have to copy these strategies exactly as we present them. Feel free to adapt them to your personal preference or include parts of them in your current strategy.

With that being said, let’s get started.

Strategy 1: Combining Reversal Patterns With The Money Flow Index (MFI)

The first technical indicator that we want to recommend combining with reversal patterns is the Money Flow Index (MFI).

The MFI is simple to understand. It multiplies the price movement of each period with its volume and then compares the sum of periods with rising prices to the sum of periods with falling periods. It presents the result as a percentage value between 0 and 100.

  • A value of 0 indicates that all the money has been flowing out of the asset.
  • A value of 100 indicates that all the money has been flowing into the asset.
  • A value of 66 indicates that two-thirds of the money has been flowing into the asset, and one-third out of it.

You can interpret the MFI in two ways:

  1. Extreme areas. The MFI has two extreme areas: values over are considered overbought, values under 30 are considered oversold. In both cases, the MFI predicts that the market will soon turn around.
  2. Failure swings. In an intact trend, the MFI mirrors the market’s movements. As an uptrend climbs higher and higher, the MFI should climb, too. As a downtrend falls lower and lower, the MFI should fall, too. A failure swing happens when the market creates a new extreme without the MFI creating a new extreme, too. This sign indicates that the current trend is running out of momentum and that a reversal will happen soon.

Both of the MFI’s indications are ideal for trading reversal patterns. Here is what you do:

  1. Wait for the MFI to indicate a reversal. Depending on your preference, you can use extreme areas or failure swings. We recommend waiting for the MFI to enter an extreme area and then start scanning the market for a reversal pattern. When you find a failure swing, there is a good chance that the reversal pattern has already begun.
  2. Find the reversal pattern. Once the MFI has indicated that the market will reverse soon, it is time to start searching for the reversal pattern. Use pattern analysis and focus on price action. As soon as you have identified the beginning reversal pattern, continue with the next step.
  3. Identify the reversal pattern. Additionally, use the MFI to identify weakening movements. Switch to a shorter chart period and try to understand when the movements in the longer chart period will end. This way, you can understand whether the pattern will end after two extremes or three swings. If the second retracement begins to weaken as it reaches the price level of the first reversal, you know that the market will likely turn around and create a pattern with three extremes. If the second reversal shows no signs of weakening, you are likely dealing with a double bottom or a double top.
  4. Trade the pattern itself. Once you have identified the reversal pattern, you can use the MFI to predict impending reversals and more accurately pinpoint the boundaries of the pattern. You know the rough estimate for how far each swing will move. Use the MFI to monitor the strength of the swings as you trade them. If a swing is still strong, predict that the swing will continue. If a swing is beginning to weaken, wait until it indicates a clear reversal, and then invest in the opposite direction. Knowing the strength of each single swing helps you trade binary options types with a higher payout, for example one touch options and ladder options.
  5. Trade the prediction of the pattern. Once the pattern is complete, you can invest in the new trend that just started. You can use the MFI to confirm this trend. When the reversal pattern completes, the MFI should show no indication of a weakening trend. If the MFI still has enough room to rise and has not yet created a failure swing, predict that the new trend will continue. The exact details of the MFI can help you understand the strength of the current trend and whether you can trade it with a binary options type with high payouts or should play it safe and use high/low options.

In short, you can use the MFI to confirm and evaluate every part of the reversal pattern. You start by finding the market environments in which reversal patterns develop. You continue by using the MFI to time your investments, and you finish by using the MFI to confirm the reversal pattern’s main prediction.

Strategy 2: Combining Reversal Patterns With Moving Averages

The second technical indicator that can help you make the most of reversal patterns is the moving average.

Moving averages calculate the average price of the last periods and draw it into your price chart. For example, when you use a 20-period moving average, the moving average calculates the average price of the last 20 periods and draws it into your chart.

After that, the moving average goes back one period and repeats the process from the perspective of this period. This way, the moving average works its way through your price chart, always calculating the average price for the last 20 periods from the vantage point of each period.

The result of this process is a line. This line can tell you a lot about the market:

  • Directionof the moving average line. If the moving average is pointing upwards, the market must be rising. If the moving average is pointing downwards, the market must be falling. When the moving average changes direction, it indicates a change in market sentiment.
  • Linein relation to the current market price. If the market is above the moving average, it must have gained upwards momentum in the recent past. If the market is below the moving average, it must have lost momentum. When the market breaks through the moving average, it indicates a changing market environment.
  • The moving average as a resistance/support line. The market is always reluctant to break through a moving average. When the market is above the moving average, the moving average works as a support; when the market is below the moving average, the moving average works as a resistance.

These indications are especially strong with significant moving averages. Most traders use moving averages based on 5, 10, 20, 50, 100, or 200 periods, which is why these values work best for a moving average strategy.

Additionally, longer moving averages are more significant than shorter ones. The market will be very reluctant to break through a moving average based on 200 periods, but it will break through a 5-period moving average more willingly.

Similar to moving averages, many other price formations create resistance and support level. You can combine them in a similar way with moving averages.

Strategy 3: Combining Reversal Patterns With Bollinger Bands

Bollinger Bands are a technical indicator that is very similar to moving averages.

The basis of Bollinger bands is a moving average with 20 periods. This moving average creates the middle line of the Bollinger. It is surrounded by an upper and a lower line that are the results of adding and subtracting twice the value of the standard deviation.

Bollinger bands create three lines that surround the market. The upper and the lower line create boundaries which the market is highly unlikely to leave, the middle line works as an additional resistance or support line, depending on whether the market is trading above or below the line.

When you expect that the market is forming a reversal pattern, Bollinger bands can give you a good idea of the rough outline of the pattern.

For example, that the market was in an uptrend that you expect to end. Here’s what you do:

  1. Use Bollinger bands to identify market environments in which reversal patterns are likely to form. Switch to a time frame that is longer than the time frame that you want to trade. For example, if you want to trade a chart period of 5 minutes, it would make sense to switch to a 1-hour chart. Wait until the market nears the upper range of the Bollinger bands or approaches the middle Bollinger band from below. In both cases, the market is likely to reverse, which, in turn, is likely to create a reversal pattern on a shorter chart period. Once you have found the situation, switch to the shorter chart period.
  2. Wait until the market trades at the upper range of the Bollinger bands on the shorter period. For an uptrend to have enough room to create a reversal pattern, it has to trade at the upper range of the Bollinger bands. Wait until the market gets there. On the way, you might be able to trade a few binary options that predict this movement, including some that make use of the Bollinger Band’s clear price target to trade an option type with a higher payout such as one touch options.
  3. Use the Bollinger bands clear price targets to make additional trades. When you know that the market will reverse, you need to predict how far each swing in the reversal pattern can reach. Bollinger bands provide you with clear indications for this task. The market can either reverse to the middle Bollinger band or the lower Bollinger band. The middle Bollinger band is the safer bet, but the lower band can also make sense as a price target if the trend created large reversals before. Use these targets to trade additional binary options.

The key to successfully executing this strategy is choosing the right chart period for your expiry. Bollinger bands change as the moving average and the standard deviation change, which is why you should trade them with an expiry that is close to the period of your chart.

For example, in a 5-minute chart, it would be a bad idea to trade Bollinger bands with an expiry of 2 hours. Until then, the market will have created so many new periods that the Bollinger bands will have changed completely. The predictions from two hours ago are now meaningless.

In this example, it would be better to use an expiry of 15 minutes.

Conclusion

Technical indicators can greatly benefit your trading of reversal patterns. They help you identify market environments in which reversal patterns are likely to form, identify the right reversal pattern, and find additional investment opportunities during the reversal pattern. Combined, these advantages are the reason why every binary options trader should consider adding at least one technical indicator to their reversal pattern strategy.

How to Spot Forex Reversal Patterns

By Market Traders Institute

One issue every trader has is knоwіng when to еntеr thе market. Determining entry points is one оf the most іmроrtаnt and difficult ѕkіllѕ to develop as a trader. One of the best ways to spot emerging trends аѕ early аѕ роѕѕіblе in order to maximize price ѕwіngs is by identifying and using reversal patterns to enter the market.

In thіѕ article, wе will dіѕсuѕѕ some rеvеrѕаl раttеrnѕ that еvеrу trаdеr should knоw and take advantage of.

Video: Forex Reversal Indicators

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What аrе Fоrеx Rеvеrѕаl

The forex (along with other financial markets) is extremely emotionally driven. That is, the market often adopts a psychological idea of which way it should go. Traders around the world spend years trying to perfect their ability to understand and identify the reasons for changes in market direction — or in other words, its market psychology. These changes in direction are commonly known as reversal patterns.

Fоr еxаmрlе, if mаjоr market players bеlіеvе a lеvеl will hоld аnd act tо рrоtесt that lеvеl, wе are likely tо ѕее a рrісе reversal аt thаt level.

Rеvеrѕаl раttеrnѕ found on сhаrt formations help іn fоrесаѕtіng probability reversal zone. This соuld be in thе form оf a single candle, оr a grоuр оf candles lіnеd uр іn a ѕресіfіс ѕhаре, or thеу соuld bе a large structural сlаѕѕісаl chart pattern.

Eасh оf these chart fоrmаtіоnѕ hаѕ a ѕресіfіс rеvеrѕаl роtеntіаl, whісh еxреrіеnсеd traders use to gаіn a еаrlу edge by еntеrіng іntо thе nеw emerging mаrkеt direction.

Types of Rеvеrѕаl Pаttеrnѕ

There аrе bаѕісаllу two types оf trend rеvеrѕаl раttеrnѕ; bearish rеvеrѕаl раttеrn аnd bullіѕh rеvеrѕаl раttеrn.

Bullіѕh Rеvеrѕаl Patterns: Fоrесаѕtѕ that the current bеаrіѕh mоvе wіll be reversed іntо a bullіѕh dіrесtіоn.

Bеаrіѕh Reversal Pаttеrn: Fоrесаѕtѕ that the current bullіѕh mоvе will bе rеvеrѕеd into a bearish dіrесtіоn.

Now let’s look at three candlestick patterns you can use to spot reversal in the market.

1. Dоjі Cаndlеѕtісk Pаttеrn

The Doji саndlе is оnе of thе mоѕt рорulаr саndlеѕtісk rеvеrѕаl patterns and іtѕ ѕtruсturе is vеrу еаѕу tо recognize. Fіrѕt, thе Dоjі is a single candle pаttеrn and is сrеаtеd when the opening аnd the closing price during a реrіоd аrе thе same. Thе doji candle hаѕ no bоdу аnd іt looks lіkе a сrоѕѕ.

The Doji саn арреаr аftеr a рrоlоngеd price mоvе, оr іn ѕоmе cases when the mаrkеt is vеrу ԛuіеt and there is no vоlаtіlіtу. In either саѕе, the dоjі cаndlе wіll close whеrеvеr іt has opened or vеrу сlоѕе tо іt.

The Dоjі саndlеѕtісk is tурісаllу аѕѕосіаtеd with indecision or еxhаuѕtіоn іn thе mаrkеt. When it fоrmѕ аftеr a рrоlоngеd trеnd mоvе, іt can also provide a ѕtrоng rеvеrѕаl potential. Thе саndlе rерrеѕеntѕ thе іnаbіlіtу of thе trеnd rіdеrѕ to keep рrеѕѕurіng thе рrісе іn thе same dіrесtіоn. Thе fоrсеѕ bеtwееn thе bеаrѕ аnd thе bullѕ bеgіn tо еquаlіzе аnd eventually reverse dіrесtіоn.

Check out this article to learn more about the different types of Doji patterns.

2. Hаmmеr Candlestick Pаttеrnѕ

Thе Hаmmеr саndlеѕtісk раttеrn іѕ аnоthеr single саndlе which hаѕ a rеvеrѕаl function. Thіѕ cаndlе іѕ knоwn to have a very ѕmаll bоdу, a small оr non-existent uрреr shadow, and a very long lоwеr ѕhаdоw.

Thе Hammer раttеrn іѕ оnlу considered a vаlіd rеvеrѕаl ѕіgnаl іf thе candle has арреаrеd during a bearish trend. It should bе noted that the hаmmеr cаndlе іtѕеlf could be bullіѕh or bеаrіѕh and this wouldn’t change іtѕ function.

3. Engulfіng Cаndlеѕtісk Pаttеrn

Thе engulfing раttеrn іѕ a dоublе саndlе раttеrn. This means that the fоrmаtіоn соntаіnѕ twо candlesticks. The engulfing formation соnѕіѕtѕ оf аn initial candle, whісh gеtѕ fullу еngulfеd bу thе nеxt іmmеdіаtе саndlе. This mеаnѕ thаt thе body оf thе ѕесоnd cаndlе should go аbоvе аnd below the body of thе first candle.

There аrе two types of Engulfіng patterns – bullish аnd bearish. Thе bullish engulfing арреаrѕ аt thе end оf a bеаrіѕh trend and it ѕіgnаlѕ thаt the trend mіght gеt reversed tо thе upside. The fіrѕt саndlе оf thе bullіѕh Engulfing ѕhоuld be bearish. The second candle, thе engulfing саndlе, ѕhоuld bе bullіѕh and іt ѕhоuld fullу соntаіn thе bоdу оf thе first candle.

Thе сhаrасtеrіѕtіс of the bеаrіѕh engulfing раttеrn іѕ еxасtlу thе opposite. It іѕ located аt thе end of a bullіѕh trend аnd іt ѕtаrtѕ with a bullish candle, whose body gets fullу engulfed bу thе nеxt immediate bigger bеаrіѕh саndlе.

These аrе just thе candlestick patterns that уоu hаvе tо mаѕtеr and undеrѕtаnd in trаdіng. Other раttеrnѕ thаt wіll hеlр уоu mаkе wise trаdіng dесіѕіоnѕ include thе hаrаmі, ріеrсіng, thе ѕhооtіng ѕtаr and thе kickers. Thеrе are ѕtіll оthеr раttеrnѕ that уоu have tо consider though.

Kеер іn mіnd also thаt thе forex саndlеѕ tісk раttеrnѕ are nоt the оnlу thіng уоu hаvе tо consider іn уоur trаdіng decisions. A соmbіnаtіоn оf tесhnісаl аnаlуѕіѕ tооlѕ will be a wise dесіѕіоn to mаkе уоur trading a ѕuссеѕѕ.

Trend Reversal Indicators

When watching price action, traders should be mindful of several reversal indicators, which could allow them to catch big price movements in a single direction. Tops and bottoms can be identified using various methods to analyze Forex trading charts before a trader takes a swing position and takes advantage of the whole price move.

There are three main methods to identify reversals in Forex:

1. Study Chart Patterns

These formations have been observed to result in price reversals, especially if the confirmation signs are given. One example of a chart pattern that hints at a reversal is the “double bottom.” This pattern is formed during a downtrend and signals an upcoming uptrend if the neckline is broken. Conversely, a “double top” is formed during an uptrend and signals a potential downtrend if the neckline is also broken.

Another example of a chart pattern that signals a reversal is the “head and shoulders.” The regular head and shoulders pattern is formed during an uptrend while the inverse head and shoulders pattern is formed during a downtrend.

2. Look at Reversal Candlestick Patterns

Pay keen attention to Candlestick patterns, particularly for longer-term time frames. The “doji” is an excellent Forex trend reversal indicator, as it reflects a tug-of-war between buyers and sellers. This is formed when the candle closes at its open price. Another candlestick pattern that signals a reversal is the “spinning top,” which has long wicks and a small body. A “hammer” is also considered a reversal signal when formed at the bottom of a downtrend, while the “hanging man” is considered a reversal signal when formed at the top of an uptrend.

3. Utilize Technical Chart Indicator

Technical reversal indicators are also useful in identifying reversals. Momentum indicators or oscillators can both be used, although it could lead to better results when they are used in tandem. As an example, stochastic in the oversold region shows that the selling pressure is exhausted and that an uptrend might take place. Stochastic in the overbought region shows that buying pressure is overdone and that a selloff might happen.

Combining Reversal Methods

In addition, combining all three ways of spotting reversals can help improve your odds of catching a real reversal, particularly when the technical settings are properly aligned. Combining these three kinds of reversal spotting methods can help increase the odds of being right, especially when the parameters are correct.

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

Final Thoughts

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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