Price is the ultimate indicator and tells us when trend reversals are occurring. By spotting trend reversals we can potentially get in early on the next major price wave. Using price as the primary input for our decisions, there are two methods for trading trend reversals. One involves a slowdown in the trend followed by a trendline break. The other requires a sharp move against the trend and then a pullback.
Spotting Trend Reversals
Before spotting trend reversals, we need to be able to spot trends. An uptrend is when the price is making overall higher swing highs and higher swing lows.
A downtrend is when the price is making overall lower swing highs and lower swing lows.
“Overall” in this case applies to the time frame being watched. A stock price is constantly wiggling up and down, but as long as significant lows and highs are moving higher, it is an uptrend. All charts created using StockCharts.com
In Figure 1 the stock is in a downtrend on the left because the price is making progress lower—lower lows and lower highs.
In March there is a transition to an uptrend. Following a major low in February, the price rallies beyond the former high seen in January. That strong move higher was enough to erase the decline seen between January and early February. That indicates a potential change in direction, but we need one more piece of evidence.
After the move higher in March the price barely pulls back and then starts to move higher again. The pullback therefore created a higher low. With a higher-high and a higher-low the downtrend is at the very least in trouble, and an uptrend is likely underway. More higher-highs and higher-lows confirm the new uptrend.
The transition to a downtrend is similar. The price will be making higher highs and higher lows. It then makes a lower low, followed by a lower high on the pullback (up), indicating the uptrend is at minimum in trouble and a downtrend is likely underway.
The sequence for the reversal isn’t always the same. Following a downtrend the price may not make a higher high to spark the reversal. Instead, the price makes a higher low. The higher low indicates the trend may be in trouble. When the price starts to moves higher again, it signals the downtrend is quite likely reversing.
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Figure 2 shows this transition from downtrend to uptrend. The price is making lower highs, but then makes a higher low indicating selling pressure is slowing. When the price rallies following the higher low it shows the downtrend is likely reversed.
A short-term uptrend reversal also occurs near the top of figure 2. The price makes a lower high followed by another move lower indicating the uptrend has lost steam. This is a short-term reversal because the overall trend could still be up; the major low near $38 in April is higher than the major low at $36 in December. Over the long-term the price is still making progress higher.
Applying stops and entry points to these methods make them viable for trading reversals.
Trading Trend Reversals
Trading a trend reversal requires an entry point and a stop loss to limit risk in case the reversal doesn’t materialize.
Downtrends are reversed by the price either making a higher high followed by a higher low, or a higher low followed by another move higher.
Uptrends are reversed by the price either making a lower low followed by a lower high, or a lower high followed by another move lower.
Figure 3 shows the price making a strong move higher, which recovers the ground lost during the prior wave of the downtrend. This strong up-move indicates the downtrend is in trouble. Following this strong move wait for a pullback (lower), and assuming that pullback makes a higher low, buy when the price breaks above the trendline of the pullback. Place a stop just below the recent low.
The same concept would apply if it was an uptrend being reversed. A sharp down move is strong enough to erase the progress of the last uptrend wave. This indicates the uptrend is in danger. Wait for a pullback higher; as long as that pullback makes a lower higher, sell short when the price breaks below the pullback trendline. Place a stop just above the recent high.
Sometimes the trend weakens before it reverses. When this occurs we apply a similar strategy.
Figure 4 shows an initial downtrend which is followed by a higher low. The higher low indicates the downtrend is in trouble. Wait for the next pullback, and then buy when the price breaks above the downward sloping trendline of that pullback. Place a stop just below the recent low. This will typically keep risk very small, relative to the potential profit should an uptrend develop.
The same concept applies to an uptrend reversal. The price is making higher highs and higher lows, but then it makes a lower high indicating the uptrend may be in trouble. Wait for a pullback (up) and sell short when the price breaks below the pullback trendline. Place a stop just above the recent high.
A trend reversal signals a major change in direction, potentially over the long-term. Therefore a specific target is not provided. Active traders may wish to exit a portion of their position at multiples of their risk.
For example, if you buy 500 shares and your stop is $2 below your entry price, look to exit some of your position at a profit of 2x your risk, then 3x risk or 5x your risk (decide on several multiples and then stick to them). Therefore, targets would be placed $4, $6 and $10 from your entry price.
This method provides defined exits, but also compensates you well for the risk you are taking should the price continue trending in your direction.
Another option for less active traders is to hold the trade until a signal in the opposite direction occurs. A signal in the opposite direction indicates the trend you are participating in is likely over. This exit method is less active, but requires continual monitoring.
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The Bottom Line
Downtrends are reversed by the price either making a higher high followed by a higher low, or a higher low followed by another move higher. Uptrends are reversed by the price either making a lower low followed by a lower high, or a lower high followed by another move lower. We can trade these reversals by entering when the price breaks the pullback trendline. This usually keeps risk small compared to the reward potential of participating in the new trend. The signals won’t always work out, and the trend may not reverse even though the signal is there. This is why it is important to make more on winning trades than on losing trades—that way even if we are right less than 50% of the time we’ll still make a profit.
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