You may have heard the saying, buy low – sell high. As traders, we want to enter a stock very close to support. So what is the Trend Reversal Trading?

This post was originally posted here. The writer, Rayner Teo is a veteran community member and blogger on InvestingNote, with username known as @Rayner and has 601 followers.

You’ve probably heard this a million times…

“Don’t trade against the trend.”

And I’ve said it myself too.

But here’s the thing…

Trend reversal trading can be crazily profitable — if you do it right.

Imagine:

You know how to identify high probability trend reversal areas.

You can catch market tops and bottoms with heightened accuracy.

You can identify potential trading setups that yield 1 to 5 risk to reward (or more).

Now…

I know it sounds too good to be true.

But it’s not.

Because after reading this post, you’ll discover the secrets to trading trend reversal like a pro.

Here’s what you’ll learn:

• The most expensive mistakes traders make when trading reversal

• What are the 4 stages of the market and why it’s essential to a trend reversal trader

• How to identify trend reversal with deadly accuracy

• Trend reversal trading setups that work

• Trend reversal trading: Entries, stops and exits

Are you ready?

Then let’s begin…

 

Do you make these mistakes in reversal trading?

Here’s the thing:

Trend reversal trading can be a profitable way to trade the markets. However, like any other trading strategy, there is a correct and a wrong way to do it.

Before I teach you the correct way to do it, first let me explain how you should NOT trade market reversals.

1. You’re catching a falling knife

For those of you who don’t know what’s catching a falling knife, it means trying to long the markets when it’s plummeting like a rock.

It looks something like this:

If you ask me…

There’s absolutely no sense in trying to catch a falling knife.

Why?

Because there’s no logical place to put your stop loss; there is no Support or market structure you can refer to.

And usually, the only way to set your stop loss is based on the equity left in your account — a surefire way to lose it.

“Rome was not built in a day, and no real movement of importance ends in one day or in one week. It takes time for it to run its logical course.”

So here’s the thing:

Trends need time to reverse their direction. It needs to sucker in “the latecomers to the party” till there is no one left to buy — and that’s when it goes in the opposite direction.

2. You’re entering on the first pullback

Now, another mistake traders make is attempting to trade the first pullback.

This means you go long when you see the market rallies after a huge decline. But often, this type of rally is only a retracement of the existing trend.

Here’s what I mean:

 

You’re probably wondering:

 

“Why do traders do this?”

Because of the fear of missing out (FOMO).

You don’t want to miss the next big move, thus you enter as soon as the markets show a sign of reversal. Unknowingly, this sign is usually a retracement of the existing trend.

And even if you catch the bottom in the markets, it’s unlikely you’ll hold the trade for long.

Why?

Think about this…

Prior to this trade, you’d probably tried to catch market bottoms often.

And while doing so, you’d have suffered multiple losses along the way — and this hurts your psychology.

So, when you finally catch a bottom in the markets, you won’t hold the trade for long as you’ll experience the fear of losing (from your earlier trades).

This makes you exit your trades quickly and you end up missing the big move.

Now, let’s move on…

The 4 stages of the markets and why it matters

Now before you can identify trend reversal, you must understand the 4 stages of the markets (a technique I learned from Stan Weinstein).

Why?

Because this gives you warnings that market conditions are about to change — which lets you plan trading decisions ahead of time.

The 4 stages of the markets can be broken down into:

1. Accumulation stage
2. Advancing stage
3. Distribution stage
4. Declining stage

Let me explain…

1. The accumulation stage

The accumulation phase looks like a range market in a downtrend.

However, from an order flow perspective, the buyers and sellers are in equilibrium (that’s why the market is in a range instead of a trending market).

Generally in the accumulation stage:

• The ratio of bullish to bearish candles are close

• The 50-period moving average is flattening out

• The price whips back and forth around the 50-period moving average

As time goes by, stops will gradually build up beyond the range as traders long near the lows and short near the highs of the range.

An example:

Now…

There’s no guarantee that the market will reverse from here.

But it alerts you to the possibility that the bears are getting weak and the bulls could take control and push the price higher above the highs of the range.

And when this occurs, it leads us to the next phase…

2. The advancing stageThe advancing phase is essentially an uptrend with price making higher highs and lows.

From an order flow perspective, the buying pressure overwhelms the selling pressure (that’s why the market is trending higher).

Generally in the advancing stage:

• There’s more bullish than bearish candles

• The bullish candles are larger than the bearish candles

• The price is above the 50-period moving average

• The 50-period moving average is pointing higher

An example:

 

Now…

The advancing stage eventually will need to “take a break” because the early buyers will take profits and sellers will look to short the markets as prices are at attractive levels.

When this occurs, it leads us to the next phase…

3. The distribution stage

The distribution phase looks like a range market in an uptrend.

It tells you the buyers and sellers are in equilibrium (that’s why the market is in a range instead of a trending market).

Generally in the distribution stage:

• The ratio of bullish to bearish candles are close

• The 50-period moving average is flattening out

• The price whips back and forth around the 50-period moving average

As time goes by, stops will gradually build up beyond the range as traders long near the lows and short near the highs of the range.

An example:

 

Now…

There’s no guarantee that the market will reverse from here.

But it alerts you to the possibility that the bulls are getting weak and the bears could take control and push price lower below the lows of the range.

4. The declining stage

The declining stage is essentially a downtrend with price making lower highs and lows.

Generally in the declining stage:

• There’s more bearish than bullish candles

• The bearish candles are larger than the bullish candles

• The price is below the 50-period moving average

• The 50-period moving average is pointing lower

An example:

Now, the declining stage eventually will need to “take a break” because the early sellers will take profits and buyers will look to long the markets as prices are at attractive levels.

When this occurs, it leads us back to the accumulation phase.

How to identify trend reversal like a pro

Now you’re wondering:

“But Rayner, how do you know if the market will break higher of the accumulation stage, and not just continue trading lower?”

That’s a great question.

The secret is this…

You want to identify an accumulation stage that leans against the Support on the higher timeframe.

Here’s how to do it:

1. Identify Support on the higher timeframe (e.g. Daily)
2. Identify an accumulation stage on the lower timeframe (e.g. 1 hour)

Let me explain…

1. Identify Support on the higher timeframe (Daily)

Look at the market to approach Support on the Daily timeframe; the more significant the level, the better.

2. Identify an accumulation stage on the lower timeframe (1-hour)

Then, go down to the lower timeframe and identify an accumulation stage.

What you want to see is for the lows of the accumulation stage to lean against Support on the higher timeframe.

As a general guideline:

If you identify Support on the Daily timeframe, then you can identify an accumulation stage on the 1 to 4-hour timeframe.

Or, if Support is on the Weekly timeframe, then you can identify an accumulation stage on 4-hour to Daily timeframe.

Trend reversal trading setups that work

Now, there are 3 ways you can trade this setup:

• Support & Resistance

• The Breakout

• The Pullback

Assuming you’re using the Daily and 1-hour timeframe combination, these setups will be found anywhere between the 1 to 4-hour timeframe.

Let me explain…

Support & Resistance

If you haven’t realized by now, the low of an accumulation stage is an area of Support (plus it’s leaning against the higher timeframe Support).

So, if you’re expecting higher prices, won’t it make sense to go long at this area?

Here’s what I mean…

Pros:

This setup offers a very favorable risk to reward as you’re entering in the earliest stage of the move. Imagine, your potential reward if the market breaks out of the accumulation stage?

Cons:

The price may not re-test Support thus not giving you an entry signal.

The Breakout

Alternatively, you can wait for the price to breakout higher and then enter the trade.

An example:

Pros:

You will catch every move as the market transit from an accumulation stage to the advancing stage.

Cons:

It could lead to a false breakout.

The Pullback

Lastly… you can wait for the pullback to occur before entering the trade. For example, when the price retraces to previous Resistance turned Support, and forms a bullish reversal candlestick pattern.

Here’s what I mean:

Pros:

This setup offers a favorable risk to reward as you’re entering at an area of value (previous Resistance turned Support).

Cons:

The pullback might never come and you risk missing the move.

Next, you’ll discover how to time your entries, stops, and exits when trading trend reversal.

Read on…

Trend reversal trading: Entries, stops and exits

So now the question is…

How do you time your entries in trend reversal trading?

Well, there are two ways to go about it…

1. Limit order
2. Reversal candlestick pattern

 

I’ll explain…

1. Limit order

You can set a limit order and enter without “confirmation”.

The good thing is you have a favorable risk to reward on your trades as your entries are near the highs/lows.

The downside is it’s psychologically difficult to buy when the market is falling (and you need the experience to know which levels are worth trading).

2. Reversal candlestick pattern

Or, you can use reversal candlestick patterns to time your entry (like Bullish Engulfing, Hammer, etc.).

So, you’ll enter a trade only after the market shows signs of reversal. However, you risk entering at a much higher price.

Here’s an example…

Bullish reversal candlestick pattern at Support:

Moving on…

How to set a proper stop loss in trend reversal trading?

When it comes to stop loss, you want to place it at a level that invalidates your trading setup.

This means if your stop loss is hit, then the pattern is “broken” and there’s no reason to stay in the trade any longer.

Here’s an example…

Let’s say you buy the breakout of Resistance.

Clearly, if the breakout is real, the price shouldn’t return into the range or else, it’s a failed breakout.

This means you can set your stop loss below Resistance where the price shouldn’t return to.

If it does, you know your trading setup is invalidated and it’s time to get out of the trade.

Here’s what I mean…

How to exit your winning trades

Now, your exits depend on your goals.

What do you want to accomplish — capture a swing or ride a trend?

Capture a swing

If you want to capture a swing, then you can exit your trades before opposing pressure steps in.

For example:

If you’re long, then you want to exit your trade before Resistance or swing high.

Here’s what I mean…

 

Ride a trend

And if you want to ride a trend, then you can trail your stop loss as the market moves in your favor.

For example, you can trail your stop loss using the 20MA.

Here’s an example…

Does it make sense?

Great!

Summary

In this trend reversal trading strategy guide, you’ve learned:

• Never catch a falling knife or trade the first pullback of a downtrend

• Understand the 4 stages of the market so you know when the price is likely to make a trend reversal

• Trend reversal trading setups: Support & Resistance, the Breakout, and the Pullback

• You can enter on a limit order or wait for a candlestick reversal pattern to time your entry

• You should set your stop loss at a level where if reached, your trading setup is invalidated and you’ll get out of the trade

• There are 2 ways to exit your winning trades, capture a swing, or ride the trend.