There are a lot of reversal strategies, but there is one that I really like, and that is the Strong Trend Reversal Strategy. It works on any time frame and in all markets I trade (stocks, forex, futures). The strategy combines the concepts of trends and velocity/magnitude, which are key ingredients for analyzing price action. With this strategy we don’t have to assume a reversal will occur, rather we wait for a number of key factors to align that signal a reversal is underway. The strategy then gets us in at an advantageous price so we can capitalize on the next major price wave in the new direction. This strategy is covered in my Stock Market Swing Trading Course, along with loads of other swing trading information, and two other power strategies (that produce a lot more trades).
Why I like this Trend Reversal Strategy
Most of the time we are better off trading with the trend, because when the price is moving in a dominant direction we typically get better reward:risk ratios…and a lot more trading opportunities. But with this strategy we can often get huge reward:risk ratios because we are getting into a reversal early (but there is still evidence that suggests a reversal is underway) which means we can typically keep our risk (difference between entry and stop loss order) quite small and our profit potential (difference between entry and profit target) quite large. That’s a good combination.
Also, this strategy is not a top or bottom picking strategy where we may face many small losses before finally catching the reversal. Nor does it rely on a pattern like a head and shoulders, which typically results in mediocre reward:risk ratio. This strategy is in the Goldilocks zone: it gets us in early, but not too early, and that leaves a lot of profit potential on the table.
This pattern will not be present for all reversals. This is a strong trend reversal, and a very specific pattern. Some reversals may occur via a different pattern.
The Concepts: Trends and Velocity & Magnitude
This strong trend reversal trading strategy is based on the tenets of trends, and also on how far and how fast price waves are moving (magnitude and velocity).
For an uptrend, we expect that the price waves up are going to be bigger than the price waves down. This has to happen in order for the price to make upward progress. If the price moves up $1, and on the next pullback the price drops $1, no progress has been made. So during a trend we expect the price to move up $1 (or whatever the case the may be) and then only pullback $0.40, $0.50 or $0.60, etc. before moving higher again (see Impulse and Corrective Waves).
But what happens when you have a wave up (and a wave up is just the price move that occurs between two significant pullbacks) that is followed by an even bigger wave down? That doesn’t fit with the movements of an uptrend. When a price wave up of $1 is followed by a down wave that is $1.20, that is a key piece of evidence that a trend reversal is underway. But we don’t act on that information right away. We will discuss where to enter a bit later.
When this type of pattern occurs we have one piece of evidence that a reversal is underway, but we want a bit more evidence before we are willing to stake our money on the assumption that this is a reversal. Therefore, we also consider velocity and magnitude. Magnitude has already been discussed. If you have a $1 move up, and a $1.20 move down, who do you think has the upper hand? The magnitude of the price waves indicate that the sellers (the move down) now have control. Velocity is also important though. What if the price spiked up $10 in one day, but then drops $11 over the course of three months? The buyers were frothing at the mouth to buy shares as quickly as possibly, while the sellers were much more tentative to sell. It took three months of selling to undo what the buyers did in one day. That isn’t a strong reversal. We prefer to have the opposite….
A rally of $10 over the course of a month should be erased by the sellers in days or weeks (a shorter amount of time). The larger and faster the price wave in the opposite direction of the trend the better (for signaling a reversal is underway).
It is important to stress here that the magnitude is the most important factor. A $5 drop in a downtrend that is followed by a much slower $5.50 rally, could signal that a reversal is underway. But when the rally in this case is fast, it just provides a bit more confirmation.
Since magnitude is most important, a $7 down wave followed by a $10 up wave is a much more powerful reversal signal than a $7 down wave followed by an $8 up wave.
There is an element to this strategy that is hard to quantify, and it is this: the reversal should “break the spirit” of the prior trend. Meaning, when you look at a chart, the reversal should leave no doubt that the overall momentum in that stock has shifted. The above concepts will guide you in this, but it will still take some practice.
The Trend Reversal Strategy Entry
Let’s get into how this strategy works and some examples.
So far, we know that we are looking for an upwave that is bigger and preferably faster than the prior down wave, or we are looking for a down wave that is bigger and preferably faster than the prior up wave. Respectively, these signal that a downtrend could be over or an uptrend could be over.
This is part of the setup, but we don’t do anything yet.
Next we are going to make an assumption that the price will retrace about 50% to 90% (it could be a little more or a little less–there are no certainties) of the last wave. If a reversal is very fast and very big, the price will often only retrace about 40% of that big reversal wave. In this case, we can look for a trade near the 40% to 50% level, instead of expecting a deeper retracement. [keep reading if this doesn’t make sense, it will in a second]
For example, assume the price was trending higher and the last wave up was $10 in distance (from start to finish). The price then falls $12, signaling that a reversal is likely in place. We now wait for the price to retrace at least half of that drop before we do any anything. In this case, that means the price must bounce by $6, or about half (or more is okay) of the prior $12 drop. This is the area that we are going to look for a trade signal.
Now, once the price has retraced about 50% to 90% of the prior wave, we are gong to wait for the price to consolidate (move mostly sideways) for at least four bars (could be days, minutes, hours…whatever time frame you are trading). These consolidations don’t occur that often (in combination with the other things we are watching for), so when they occur inside our trading area we want to be on alert for a trading opportunity.
Once we have at least a 4 bar consolidation (or three if you are brave) mark the high and low of that consolidation. A trade is only taken if the price breaks out of that consolidation in the reversal direction (in this case, the breakout must occur to the downside because of the big down wave that reversed the uptrend).
Still with me? Let go through the steps, first for an uptrend reversal then a downtrend reversal.
Uptrend reversal trade:
- Price is in an uptrend.
- A wave lower occurs that is bigger than the last up wave. Preferably the down move is much bigger, faster and breaks the spirit of the uptrend.
- The price retraces between about 50% and 90% of that downwave.
- While in that retracement area, it consolidates for at least 4+bars.
- Enter a short trade if the price drops below the consolidation low (we want to go short since the trend is now likely down). If the price breaks above the consolidation we do nothing. We either wait for a new consolidation to form (must still be in the retracement area to consider another trade) if the price keeps rising, or if the price immediately drops again we can take the short entry below the consolidation.
First, let’s look at a really nice setup that ultimately didn’t result in a trade. Unfortunately, the price never consolidated inside the retracement area, so even though everything looked nice, step 4 never developed and thus no trade (everything has to be present to trigger a trade!).
Here is the EUR/GBP currency pair. It is in an uptrend, (following a reversal from a downtrend shown in one of the charts below) and has a big up wave followed by an even bigger down wave. On that down wave I have used a Fibonacci retracement tool to show the retracement zone. The price needs to consolidate between 0.5 and 0.9 in order to give us a valid trade signal. But it does not. If you are unfamiliar with the Fibonacci retracement tool (I have edited it to only show 50% and 90% retracement levels) see Use Fibonacci Retracements to Find Entry Points.
Next, let’s look at an example that did result in a trade. This example occurred in the stock market (this pattern appears in all markets and on all time frames).
The stock was in an uptrend and then experienced a massive reversal that erased several of the prior upwaves. Once the price started to bounce we waiting for a retracement of approximately half (or more) of the decline. The price moves into the retracement area (between 0.5 and 0.9) and consolidates there for 4 sessions. The price then drops below the consolidation, triggering our short entry.
I would call this an advanced trade because the price had just made a very sharp one-day rally a few days prior to our going short and we actually only have a 3 bar consolidation here, but the day before could be included to make it four. When we see that sort of velocity I often expect the price to try to edge higher before finally topping. I often tell traders not to short into that sort of strength, but rather wait for the buying to die out more before short against it. Therefore, I have drawn a second box. This would be an alternate entry point. The price had dropped a bit and then on the rally it stalls out (consolidates) below the former high, showing that buyers have lost strength and that going short is now a higher probability play.
This example also shows that while that first decline in September and October indicated the price was likely to head lower, we can’t know exactly when that will happen. Both of these entries would have resulted in holding the trade through some sideways periods (with the price getting very close or possibly even hitting the stop loss on the second entry—stop loss will be discussed a bit later) before the bigger down move eventually came.
This pattern will often result in another drop after our entry, but not always of the magnitude we may hope for…as the EURGBP example above showed. Therefore, we also need to plan how and when we will get out of profitable trades. For this we can use a profit target, which will also be discussed a bit later.
For stocks, each quarter the companies issue earnings. On the chart above earnings are marked with an E (in a red circle) at the bottom of the chart. I do not hold short-term trades through earnings announcements. I get out the day before. For investments I do hold through earnings announcements since I am often in these trades for a year or more. But for any trade where I am just hopping in for a short-term move (a few days to a few months), then I always get out of these trades before earnings. There are so many stocks to choose form, and this pattern occurs in so many stocks, that there is no reason to hold a trade through earnings which is basically a gamble on which way the price will snap. We don’t hold through earnings because the increased volatility makes it very hard to control our risk on the trade via our stop loss, which will be discussed a bit later.
Downtrend reversal trade:
- Price is in a downtrend.
- A wave higher occurs that is bigger than the last down wave. Preferably the up move is much bigger, faster and breaks the spirit of the downtrend.
- The price retraces between about 50% and 90% of that upwave.
- While in that retracement area, it consolidates for at least 4+ bars.
- Enter a long trade if the price rallies above the consolidation high (we want to go long since the trend is now likely up). If the price breaks below the consolidation we do nothing. We either wait for a new consolidation to form (must still be in the retracement area to consider another trade) if the price keeps dropping, or if the price immediately rallies again we can take the long entry above the consolidation.
Let’s look at an example. Here is the EUR/GBP currency pair in a downtrend.
We have a major move down, which is followed by a rally that is slightly larger than the decline. We also see a lot of upside velocity on that initial move up. But the price doesn’t retrace at least 50% of that move up (on that first small pullback in September–note that the retracement tool would have been originally drawn from the July low to August high. It is only after the price keeps moving up, and we see the decline in September was pretty insignificant, that we connect the retracement tool from the July low to October high). The price then continues to trickle up into the October high. It then drops. There are no 4 bar consolidations until the price has retraced about 90% of that entire move up. Once the four bar consolidation has formed, buy on a breakout above the consolidation. This reversal ultimately ended up being the bottom of the downtrend and an uptrend ensued. It won’t always work out that well, but sometimes it does.
Stop Loss For Trend Reversal Strategy
Risk is controlled via a stop loss. If you are going short, the stop loss is placed just above the top of the consolidation from which you are entering the short from. “Just above” is a bit vague, but how far above the consolidation we place the stop loss will depend on the volatility of the asset, and what time frame you are trading on.
I like to look at prior 4 bar consolidations (on whatever time frame you are trading off of) and see how much the price moved outside of that consolidation before eventually making a bigger move in the expected direction. If swing trading stocks, typically put the stop loss at least $0.05 above the consolidation (for swing trading a forex pair, at least 5 pips). But if it is a more volatile stock, or an expensive stock, it may need to be placed $0.25, or $0.50 or a $1 above. I let the stock tell me what to do.
Look at prior consolidations and if you notice the stock has wiggled out of prior consolidations by $0.15, $0.31 and $0.25 on the last few consolidations before eventually having a bigger move, then place your stop loss $0.35 to $0.40 above the consolidation to give the trade enough breathing room. If you are day trading, you may place the stop loss $0.01 or 1 pip above the top the consolidation, but again, alter this based on what you see on the chart per the guidelines above.
If you are going long, the stop loss is placed just below the bottom of the consolidation from which you are entering long from. Once again, “just below” means that you need to accommodate for the volatility of the asset, per the guidelines above.
Here is a zoomed in shot of the EURGBP long trade, showing where to place the stop loss once the trade has been entered.
Getting Out of Profitable Trades
Anyone can get into a trade, but the skill comes in getting out. Our stop loss helps us control our risk at the outset of our trade. The strategy doesn’t work all the time, so the stop loss gets us out at a predetermined point if the price keeps moving against us.
So our risk is managed, but what about if we get it right? As the examples show, sometimes after we get in the price moves a bit in our favor and sometimes it moves a whole lot in our favor.
I have found that typically the pattern provides at least a decent-sized move in our direction after entry (on the trades that work…remember, not all trades will be profitable). “Decent-sized” is relative to recent waves. If we go long I usually expect the price to rally to the prior high (where the Fibonacci tool is drawn from) or possibly higher. If we go short, I usually expect the price to drop to the prior low (where the Fibonacci tool is drawn from) or possibly lower.
Therefore, as a general rule, place your profit target just above the prior low if going short, and just below the prior high if going long. This is a good conservative target that is likely to get hit.
If you look back at the charts above, you will see the price would have hit this conservative target on each trade (some target examples are also shown below). Many trades will stall and reverse at the prior high/low. Many other trades will keep moving past that high or low. Unfortunately, we don’t know which scenario will arise ahead of time. So taking the profit near the prior high/low is a good idea.
A trailing stop loss can also be used as an exit method.
The Reward MUST Justify the Risk
Before a trade signal develops, and before any trade is taken, we already know our entry point (because the consolidation has formed and we know its high and low points), we know where our stop loss will be placed if a trade signal develops (outside the consolidation on the opposite side from our entry), and we know where our target will be (near the prior high/low). With this information we can calculate our reward:risk (R:R) ratio.
Assume you buy a currency pair at 0.7035 (just above the consolidation high).
You place a stop loss at 0.6970 (just below the consolidation low). You now know your risk is 65 pips (or 0.0065).
You know where the prior high was, and place your target just below it. You choose 0.7420. Your profit potential is therefore 385 pips (0.7420-0.7035=0.0385).
With all this information you can see that if the pattern works out you stand to make much more on a winning trade than you would lose on a losing trade. And that’s a good thing, because if you make more on your winners than you lose on your losers, those losers don’t hurt very much compared to how much you rake in on the good trades. In this case, your R:R is 385:65, or 5.92:1. If you risk $100, you either lose $100 or make $592. That’s a pretty good trade off.
And remember, you will calculate this before even taking the trade. For this type of pattern, R:Rs of 4:1 or higher are quite common. Avoid trades that are 2:1 or lower. And since you will typically find lots of patterns with 4:1 ratios, I tend to leave the 2:1 trades alone as well.
This example is actually the EURGBP trade shown above. It is shown again here. The red marks the area between the entry and our stop loss, which is our risk. The green marks the area between the entry and the profit target, which is our profit potential. This drawing tool (available on TradingView), shows that our reward:risk on the trade is 5.92:1 (look near the entry).
If we look at the Pandora stock example, we can see that the first trade would have resulted in a 3.42:1 Reward:Risk ratio.
That is decent, but small details can make a big difference. While waiting for 4 bar consolidation is recommended, by incorporating that first bar our consolidation is much larger than if we only used the latter 3 (and shorted on a breakout below those 3 bars). Our stop loss and target stay the same, but our entry would be slightly higher. In this case, our R:R jumps up to 4.67:1. That is better. There is a fine line between being too aggressive (trying to keep the risk so small that you always get stopped out) and taking advantage of better prices when the market provides them to you to improve your R:R.
The Biggest Problem I See People Have
If you don’t have good results with the strategy, chances are you are too focused on tiny waves. Reversals of tiny waves mean nothing, they are noise. Tiny wave reversals don’t “break the spirit of the trend”. Focus on the big waves (on whatever time frame you are trading), not the tiny gyrations that occur within them. Isolate the major waves, and reversals of them (even bigger waves) and you will likely find the strategy works well for you.
Final Word on the Trend Reversal Strategy
This is a great strategy. It is one of my favorites. Not only is it useful for trading purposes, but even if you aren’t involved in a trade it will let you know when a trend may be turning. Nothing works all the time, but if you practice this strategy you will start to see its power. Not all trends reverse this way, this is just one pattern that may appear. Practice this strategy before utilizing it with real capital. You should be winning at least 50% of your trades in the demo account before you switch to real capital. And if you are winning 50%+ of your trades, and your winnings trades are bigger than your losing trades, you will be doing very well. If you aren’t profitable, go back through the guidelines. Keep honing your approach and zeroing in on assets that better align with the guidelines until you are profitable.
By Cory Mitchell, CMT
If you want to learn more about effectively utilizing this strategy in the real world, as well as more trading strategies (ones that occur more frequently than this one) then check out my Stock Market Swing Trading Video Course
Knowing the basics of the strategy isn’t enough to be able to implement it effectively in the real world. You also need to know about analyzing trends, proper position sizing (how many shares or lots or lots to buy or sell), what order types to use, when to trade this pattern and when not to trade it, and how to find/screen for these types of trades (waiting for random ones may mean you never get the opportunity to trade this pattern). All these topics, and more, are covered in the video course.