Introduction
Pick up any trading book
or listen to any market guru out there and you'll likely hear them
repeat the adage "trade with the trend." Although that is fine and dandy and
especially true over the long haul, trading with the trend is not the only way
to trade. In this lesson, I'll present you with a methodology to trade
potential trend reversals. This method of identifying and trading potential
reversals is nothing new. It's a comprehensive method that incorporates price,
pattern, and time. When you look for reversals, you want the weight of the
evidence to suggest that the trend is about to end, at least for the short
term.
First off if everyone is trading with the trend,
why should you bother trading reversals?
- Buy Low /Sell High or Sell High/Buy Low - If
you buy at a low price and sell at a high price, you make money (vice versa
for shorts), but obviously it's not as simple as it sounds. As we know, when
things get too one-sided, it's often a signal to start going the other way.
Even Bernard Baruch said "buy when there is blood on the streets". Or as Larry
Connors said
"buy the fear and sell the greed".
- Trends don't last forever - Markets don't go
straight up or straight down. A stock in an uptrend will pull back, but
position yourself for what could be more than a pullback. Once a trade is
working in your favor, you should look to take some of the position off and
let the rest ride if the pullback turns into a full-fledged reversal.
- Good potential risk to reward - When trading
reversals, the violation of a prior swing high or low is the best indication
that you are wrong. Often times, these points are not too far away and can
provide you with trades that have good potential risk-to-reward ratios.
Identifying Potential
Reversals
So is every new high or low a suspect for a
reversal? Should you be ready to short every new high or buy every new low? Of
course not! You need to identify those new highs or lows that have a high
probability of reversing.
Here's how I do it:
- Identify an "Extreme" - Not every swing high
or low will be significant.
- Check for an reversal pattern - Is it telling
me a story?
- Identify price support levels - Is the up move
running into a brick wall? Or is the down move getting close to strong
support?
- What are the oscillators saying? Do they agree
or disagree?
- Is time on your side?
Identifying An "Extreme"
I'm not interested in just any swing high or low,
I want the new high or low to be an "extreme" high or low. I am looking for a
market that has gone up or down too far too fast. What do I mean by "extreme"?
Well, I keep it simple as I use Bollinger Bands to help me to identify an
"extreme." I use the standard 20-period moving average with two standard
deviations plotted above and below the moving average.
For potential shorts, I want to see the high
penetrate the upper band and close in the lower half of the range and preferably
below the open. For potential longs, the low should penetrate the lower band and
the close should be in the upper half of the range and above the open.
Entry for a short is one tick below the
yesterday's low whereas entry for a long trade would be one tick above
yesterday's high. Software packages such as SuperCharts, Metastock, Tradestation,
or Telescan will allow you to scan for these stocks.
Checking For A Reversal
Pattern
Is the new high or low a piece of the potential
reversal puzzle? And is it the final piece? Does the new high or low complete
the "3" point of a 1-2-3? Or how bout the "5" point of my favorite reversal
pattern, the
Wolfe Wave? What about a Gartley "2 Step" or butterfly pattern? Go through
each of your extreme stocks and check for these two patterns or any other
reversal pattern that you like to use.
Checking For Important Price
Levels
Run the Fibs from recent swing highs or lows and
see if you get at least three or more Fibonacci price relationships in the
vicinity. These price relationships can be either retracements, extensions, or
projections. I'd usually liked to see price trade into the zone and then back
off.
Checking The Oscillators
I like to use oscillators solely for divergence
analysis. Whenever price makes a new high but the oscillator doesn't, you then
have a negative divergence with potentially bearish implications. If price makes
a new low but the oscillator doesn't, you then have a bullish divergence with
potentially bullish implications. The level of the oscillator does not matter
since overbought can become even more overbought and oversold can become even
more oversold.
Therefore all I'm checking for is that the new
high or low in price is accompanied by a new high or low in the oscillator. I
use three different oscillators and I like to see a divergence in at least two
of them. The oscillators I use are:
- Stochastics - Available on any charting
software, the stochastics oscillator compares the closing price to its range
over a certain period of time. I like to use the standard 14-3-3 setting.
- Open Close Oscillator - This oscillator
compares a market's closing price in relation to its open. Generally speaking
if the close is above the open, it's bullish whereas if the close is below the
open, it's bearish. The Open Close Oscillator takes the summation of the
closes for a given period and subtraction the summation of the opens for a
given period. I like to use a 11 period summation of the closes minus the 11
period summation of the opens.
- RSI - This is an slower moving oscillator.
Therefore I use a 5 day setting.
Timing Cycles
Besides price support and resistance, I also want
to see support and resistance on the time axis. Once again, there should be a
cluster of at least three timing relationships that are pointing to or near a
particular date in the future. Be aware this isn't an exact science, so give it
plus or minus one or two days to pan out. Both Qcharts and Esignal allows you to
do Fib on the time axis.
Putting It All Together
Since the Oct.10, 2002 low,
Eastman Kodak (EK | Quote | Chart | News | PowerRating) has a near 60% run to the upside. On Jan.
13, 2003, the stock traded to a new 52-week high, however, it penetrated its
upper Bollinger Band and closed in the bottom half of its range. The stock also
appeared to have formed the fifth point of a Wolfe Wave pattern.
In addition, today's high also bumped up against
the 1.618 retracement of the Dec. 2 high. And there are a couple more resistance
zones up ahead. Furthermore, both the RSI and Stochastics oscillators are flat
even though prices made a new high. This has potentially bearish implications.
Lastly, check to see if any timing cycles are in
effect. There are three time cycles that are calling for a high between Jan. 9
and Jan. 10. The 11th and 12th was Saturday and Sunday so Monday's high is still
within the cycle. A trigger to go short would be one tick below the low at 39.86
and a stop can be placed one tick above the high of 41.08 or just above the
cluster of overhead resistance. The stock slides for the next few sessions and
really sold off after a profit shortfall on the 21st.
Many times, the 20-day moving average will act as
support, therefore you might want to use 2 for 1 money management and take half
of the profits off the table. You can leave a part of the position in case a
further sell-off does take place. If you have any questions on this methodology,
please feel free to contact me.
Vincent Mao
