How I Trade Reversals

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:

1. 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.
2. 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.
3. 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