Basics of the Reversal Trading

I always try to be orderly in all aspects of life, including this blog. I believe that this facilitates the understanding and analysis of the facts. Thus, following that philosophy, here I will present my ideas on the profitable but risky Reversal Trading, to continue my trilogy of trading types using Price Action, which includes the previous post on Trend Trading and the next on Breakout Trading. Within this Wyckoff's classification remains the Range Trading, which I usually avoid. 

Just as a comment, Wyckoff elaborated its classic, and still valid, theory back in 1922. He was so lucid to understand that times, economic environments, companies, and even countries can change or disappear, but there is something that does not change or will change, and it is the human mind, who is finally the one who governs the decision of the trader. Greed and Fear. Psychology. That's the reason why technical analysis will always work.

As I wrote in the previous posts, I use Reversal Trading a lot, but it is not exactly my favorite. If I recognize it is the most attractive for the excellent profits it can give when a successful trade is achieved. In the end, it all has to do with the trading style and the risk/reward that each trader wishes to assume: the risky ones (because it is generated against the trend) opt for Reversal Trading, and the more conservative ones prefer the Trend and the Breakout Trading.

The big dilemma

As well as being the most exciting and profitable, reversal trading is also the most difficult. A clear example is the current bear market. Bull traders are desperate buying soon any price rebound hoping it will be the bottom, the desired breakpoint, and the start of the bullish reversal. The FOMO (fear of missing out) trade invades his psychology. In the end, they discover that it is just one more pullback in the current downtrend, and the losses come, strongly usually. At some point, the reversal will happen, obviously, but when: that is the dilemma of the reversal trader. 

Again, we must refer to the Wyckoff phases and Price Action Analysis to try to answer this dilemma and to correctly identify when the accumulation or the distribution phase ends to give way to the expansion or contraction stage respectively, that is, the reversal itself. And the way is to see it in different timeframes with the appropriate candlesticks, distinguishing pullbacks from breakouts, always at key support or resistance levels. That is, the usual "rules", but this time with slight variations.

As seen in this chart of an ideal reversal, taken from forex.doc, the elements are always the same: check the dominant structure and signs of weakness (such as longer and more continuous counter-trend candles), and decide the precise breakout, always generated and confirmed by the right candles.

Note that a reversal can be violent, as in these charts, or come after a slow period of low volatility, typical of the accumulation or distribution phases, where energy is accumulated for the next big move.

Then, how a reversal works?

Unlike what is seen for trend trading, where everything is expected to happen after a rejection at a key level, this time for reversal trading, we need to look for price patterns that have formed right before a trendline break. That’s because we are going countertrend and need to see momentum loss. Then apply price action and candlestick basics. 

As told before, it's highly recommendable to analyze this price action in at least two timeframes. In the higher, to define the trend, the price pattern, the support/resistance key level, and finally, decide there to trade or not. In the lower, the operative, you can see the swings, immediate trendlines, and candlestick patterns in more detail.

About the price patterns, my favorites for reversal trading are the double-top and double bottom, which are shown in the chart below, taken from, a great trading site.

The rules are simple: first, identify the main trend. In this case bullish, with a clear HH-HL structure that needs to be broken. Then, at the purple level, is complete a double-top price pattern. That means momentum loss as the price failed to make a higher high.

As is shown, riskier (I would say the hurry ones) traders enter short at that level, as a red engulfing reversal candle appears at that point. It's valid. Gets more reward, but with a more risky trade.

Conservative traders, verify a lower timeframe for the best analysis and wait until the trendline break, simply because you are going against the dominant trend, and need to be cautious. Just a trendline break isn't enough: can be another pullback of the main trend, the most common mistake of a reverse trade. Must wait for more signals as a confirmation candle, otherwise, it could de a false breakout or a whipsaw beginning. 

Entry and Exit

My entry, as for any of the four typical existing trades, will always be decided by the Price Action Analysis, following the ideas from the example above, and better using a stop order. Probably won't have the favorable risk/reward as a limit order, but it's more secure to avoid a bad entry. 

And I always place the stop-loss according to the price structure, usually at an obvious support/resistance level or structure, plus a gap. As usual, place it where if reached invalidates your initial bias.

The risk management of the price movement for a successful exit is different than with trend trading: For a reversal trading I prefer to consider initially capturing the swing move, with a defined risk-reward, that`s a fixed stop-loss and also fixed target levels. If the reversal becomes a strong rally with the market moving in my favor, I change and consider then riding the trend, trailing the stop-loss as explained in the Trend Trading post.

As you have seen, I focused exclusively on simple price setups. This kind of simplicity, hard to grasp at first, is, in my opinion, the most successful way to trade, obviously, after many hours of observing and analyzing the price action in the charts.

Applying the theory

During the covid pandemic, the SP500 had a predictable long-term bullish behavior supported by the Fed's dovish policies: low i-rate, and intense stimulus through the QE. Trend trading was the logical move, although there were also good opportunities for reversal traders.

Let's review what happened in the second week of June 2020 with the $SPY, through its 1-hour chart, shown below. 

As the big trend in the daily chart (not shown) is bullish, we use this timeframe for more details. After the Monday explosion, the $SPY price began losing momentum and showing candle rejections in the midday Tuesday session, especially when touched the Fibonacci level of $313.22, the green line.

On Wednesday a double-top pattern was formed at the (grey) resistance zone, so we need to wait for a breakout of the immediate (yellow) uptrend line. When the price broke, a big momentum candle appeared, with increasing volume: that's a good confirmation for a reversal trade. Go ahead to the 15-min chart (not shown) to decide the correct place to enter your short trade. Place a fixed stop loss at the double-top level and a fixed target at the most recent swing-low level (near $310, the yellow upper-narrow) to capture the swing move.

The exact behavior was repeated three more times with the same typical move (!): rising to a level forming a double-top, an immediate trendline break (also breaking the black-line EMA50, which reinforces the signal), and a big momentum candle confirmation with increased volume.

Reversal trading gives great profitable opportunities, more than any other strategy. Just follow your plan and be patient, as a sniper, waiting for it. Remember trading is not just charts: it's mostly risk management and psychology: patience, emotional intelligence, discipline.

Good trading,

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