Tips on How to Trade With the Trend and Spot Reversals

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Tips on How to Trade With the Trend and Spot Reversals

Trend trading seems like it should be easy, but when you’re first learning about trends your trades will likely end up on the wrong side of a lot of them. This is usually a result of not fully understanding the nature of trends, and the common mistake of trading against the trend because you think a reversal is starting. Here I’ll show you a few tips that’ll help you understand the dynamics of trends and trend reversals, and how to get in on both.

Impulses and Corrections

Price doesn’t move in one sustained direction for long. Even during a strong trend, the price impulses strongly, then corrects, then impulses and so on. Therefore, during a trend there are two main environments that occur–impulses and corrections.

Impulses occur in the direction of the larger trend, and typically cover a large price area, even though the impulse doesn’t necessarily last long. These are very strong moves, and ultimately the ones we want be trading with.

Corrections on the other hand are movements against the trend. Corrections cover less price area than impulses. The smaller corrections allow for the price to make head way in one particular direction.

Impulses and corrections can both be either up or down. There is a misconception that corrections are always moves to the downside. This is not true. A correction is simply a move against the more dominant trend. So if the impulses–large price moves–are to the downside, then corrections will be to the upside.

Figure 1. AUD/USD – 15 Minute Chart with Impulses (Yellow) and Corrections (White)

Trading with the Trend

Ideally you want to trade in the direction of the impulses, and corrections provide you with the entry points. Two potential entry methods were covered in my articles Trading the “Mini-Channel Breakout” and Capitalizing on Lower Highs and Higher Lows in Price.

Sounds simple. If the large moves are to the upside, you wait for a correction and then use an entry method (such as the ones described in the aforementioned articles) to get in and ride the impulse to a profit.

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But a trend, which consists of both impulses and corrections, won’t last forever. Eventually the impulses will begin to move in the opposite direction.

Figure 2. AUD/USD – 15 Minute Chart with Trend Change

Spotting Potential Reversals

In order to trade with the trend, you also need to spot reversals. If you can’t spot reversals you will end trading with the old trend, and losing money.

Here are a couple ways to determine when a trend reversal may be occurring:

  • An uptrend is created by higher swing highs in price, and higher swing lows. Therefore, if an uptrend fails to make a new high (creates a lower high), or creates a lower swing low, a reversal is potentially is underway. This doesn’t mean the uptrend is over, it simply means the uptrend is in question and therefore it is best not to trade until a new trend–either up or down–emerges.

A downtrend is created by lower swing lows in price, and lower swing highs. Therefore, if a downtrend fails to make a new low (creates a higher low), or creates a higher swing low, a reversal is potentially is underway. This doesn’t mean the downtrend is over, it simply means the downtrend is in question and therefore it is best not to trade until a new trend–either up or down–emerges.

  • Watch the magnitude and direction of impulses. On the left half of figure 2 the impulses are down, in other words, the bigger moves are to the downside. On the right half of the chart, the moves to the upside are larger. Always ask yourself “In which direction are the moves larger?” When a shift occurs, as in figure 2, it signals a potential trend change. We always want to be on the side of the impulses, so trade in the direction of the biggest moves.

If you notice a market environment where both up and down moves are of similar magnitude, then you’re likely in a trading range or a choppy market environment because the price can’t make much progress one way or the other. I personally don’t trade during these times; I would much rather wait until a trend develops.

Most traders hear very early in their education that they should trade with the trend. Before that can happen though, you need to understand that price trends via impulses and corrections. Impulses and corrections both create a trend; it is simply the direction of the impulses which determines if the trend is up or down. In an uptrend watch for a lower high or lower low; in a downtrend watch for a higher low or higher high. These are both warning signs to avoid trend trading until a trend is re-established. Also, watch the magnitude of the impulses. When the larger moves start occurring in a different direction, a trend reversal is possibly underway. While it is not possible to know when every reversal will occur, or to always trade with the trend, avoid trading when the trend is in question and always try to trend trade in the direction of the largest moves (impulses).

Market Reversals and How to Spot Them

Capturing trending movements in a stock or other type of asset can be lucrative. However, getting caught in a reversal is what most traders who pursue trendings stock fear. A reversal is anytime the trend direction of a stock or other type of asset changes. Being able to spot the potential of a reversal signals to a trader that they should consider exiting their trade when conditions no longer look favorable. Reversal signals can also be used to trigger new trades, since the reversal may cause a new trend to start.

In his book “The Logical Trader,” Mark Fisher discusses techniques for identifying potential market tops and bottoms. While Fisher’s techniques serve the same purpose as the head and shoulders or double top/bottom chart patterns discussed in Thomas Bulkowski’s seminal work “Encyclopedia of Chart Patterns,” Fisher’s methods provide signals sooner, giving investors an early warning of possible changes in the direction of the current trend.

One technique that Fisher discusses is called the “sushi roll.” While it has nothing to do with food, it was conceived over lunch where a number of traders were discussing market setups.

Key Takeaways

  • The “sushi roll” is a technical pattern that can be used as an early warning system to identify potential changes in the market direction of a stock.
  • When the sushi roll pattern emerges in a downtrend, it alerts traders to a potential opportunity to buy a short position, or get out of a short position.
  • When the sushi roll pattern emerges in an uptrend, it alerts traders to a potential opportunity to sell a long position, or buy a short position.
  • A test was conducted using the sushi roll reversal method versus a traditional buy-and-hold strategy in executing trades on the Nasdaq Composite during a 14-year period; sushi roll reversal method returns were 29.31%, while buy-and-hold only returned 10.66%.

Sushi Roll Reversal Pattern

Fisher defines the sushi roll reversal pattern as a period of 10 bars where the first five (inside bars) are confined within a narrow range of highs and lows and the second five (outside bars) engulf the first five with both a higher high and lower low. The pattern is similar to a bearish or bullish engulfing pattern, except that instead of a pattern of two single bars, it is composed of multiple bars.

When the sushi roll pattern appears in a downtrend, it warns of a possible trend reversal, showing a potential opportunity to buy or exit a short position. If the sushi roll pattern occurs during an uptrend, the trader could sell a long position or possibly enter a short position.

While Fisher discusses five- or 10-bar patterns, neither the number or the duration of bars is set in stone. The trick is to identify a pattern consisting of the number of both inside and outside bars that are the best fit, given the chosen stock or commodity, and using a time frame that matches the overall desired time in the trade.

The second trend reversal pattern that Fisher explains is recommended for the longer-term trader and is called the outside reversal week. It is similar to a sushi roll except that it uses daily data starting on a Monday and ending on a Friday. The pattern takes a total of 10 days and occurs when a five-day trading inside week is immediately followed by an outside or engulfing week with a higher high and lower low.

Testing the Sushi Roll Reversal

A test was conducted on the NASDAQ Composite Index to see if the sushi roll pattern could have helped identify turning points over a 14-year period between 1990 and 2004. In the doubling of the period of the outside reversal week to two 10-daily bar sequences, signals were less frequent but proved more reliable. Constructing the chart consisted of using two trading weeks back-to-back, so that the pattern started on a Monday and took an average of four weeks to complete. This pattern was deemed the rolling inside/outside reversal (RIOR).

Every two week section of the pattern (two bars on a weekly chart, which is equivalent to 10 trading days) is outlined by a rectangle. The magenta trendlines show the dominant trend. The pattern often acts as a good confirmation that the trend has changed and will be followed shortly after by a trend line break.

Once the pattern forms, a stop loss can be placed above the pattern for short trades, or below the pattern for long trades.

The test was conducted based on how the rolling inside/outside reversal (RIOR) to enter and exit long positions would have performed, compared to an investor using a buy-and-hold strategy. Even though the NASDAQ composite topped out at 5132 in March 2000 (due to the nearly 80% correction that followed), buying on January 2, 1990 and holding until the end of the test period on January 30, 2004 would still have earned the buy-and-hold investor 1585 points over 3,567 trading days (14.1 years). The investor would have earned an average annual return of 10.66%.

The trader who entered a long position on the open of the day following a RIOR buy signal (day 21 of the pattern) and who sold at the open on the day following a sell signal, would have entered their first trade on January 29, 1991, and exited the last trade on January 30, 2004 (with the termination of the test). This trader would have made a total of 11 trades and been in the market for 1,977 trading days (7.9 years) or 55.4% of the time. However, this trader would have done substantially better, capturing a total of 3,531.94 points or 225% of the buy-and-hold strategy. When time in the market is considered, the RIOR trader’s annual return would have been 29.31%, not including the cost of commissions.

Using Weekly Data

The same test was conducted on the NASDAQ Composite Index using weekly data: using 10 weeks of data instead of the 10 days (or two weeks) used above. This time, the first or inside rectangle was set to 10 weeks, and the second or outside rectangle to eight weeks, because this combination was found to be better at generating sell signals than two five-week rectangles or two 10-week rectangles.

In total, five signals were generated and the profit was 2,923.77 points. The trader would have been in the market for 381 (7.3 years) of the total 713.4 weeks (14.1 years), or 53% of the time. This works out to an annual return of 21.46%. The weekly RIOR system is a good primary trading system but is perhaps most valuable as a tool for providing back up signals to the daily system discussed prior to this example.

Trend Reversal Confirmation

Regardless of whether a 10-minute bar or weekly bars were used, the trend reversal trading system worked well in the tests, at least over the test period, which included both a substantial uptrend and downtrend.

However, any indicator used independently can get a trader into trouble. One pillar of technical analysis is the importance of confirmation. A trading technique is far more reliable when there is a secondary indicator used to confirm signals.

Given the risk in trying to pick a top or bottom of the market, it is essential that at a minimum, the trader uses a trendline break to confirm a signal and always employ a stop loss in case they are wrong. In our tests, the relative strength index (RSI) also gave good confirmation at many of the reversal points in the way of negative divergence.

Reversals are caused by moves to new highs or lows. Therefore, these patterns will continue to play out in the market going forward. An investor can watch for these types of patterns, along with confirmation from other indicators, on current price charts.

The Bottom Line

Timing trades to enter at market bottoms and exit at tops will always involve risk. Techniques such as the sushi roll, outside reversal week, or rolling inside/outside reversal–when used in conjunction with a confirmation indicator–can be very useful trading strategies to help the trader maximize and protect their hard-earned money.

Trend Reversals: 5 Practical Forex Tips

Enhance your ability to analyze trend reversals in the market and take advantage of them effectively by using support and resistance, chart patterns, break of trendlines, divergence, and change of our trend indicator.

The trend is your friend until it bends. Simple words and a short sentence capture the very essence which Forex traders must aim for in order to achieve success. To keep trading simple and focused on trend trades is the way to go. Maybe that is a simple message but applying tactics that turn the strategy into profits is not as easy. The Double Trend Trap strategy offers a comprehensive method for capitalizing on the trend.

This article, however, focuses on the other side of the coin which is the “until it bends” part. The trend is our friend – yes. But when does the trend bend? How does a bend look like and when do we make decisions? Five (5) practical examples are shown in this article.

1. Support and Resistance

For trend traders, it is vital to know where the key support and resistance levels are. The clash between trend and trading support and resistance has been well documented in a previous article (click here). However, the quick summary is that the trend has a high chance of either stalling or reversing at big daily and weekly tops and bottoms and trend traders need to trade with caution when a trend gets close to it. Here is an example of the GBPJPY which is not able to break through the support (magenta line).

2. Chart Patterns

Chart patterns are clear and simple communication messages from the market. Some of these patterns confirm highs odds of trend continuation; whereas other chart patterns warn of potential trend reversals. These reversal patterns include the rising and falling wedges, double and triple tops and bottoms, and the inverted and normal head and shoulders (H&S). When reversal patterns occur, trend traders want to be very cautious with current positions and avoid taking new trend trades. In the chart example below we see an inverted H&S (purple), a normal H&S (green), double top (red) and double bottom (magenta/brown).

3. Break of trend lines

Trends have angles at which they move. Trends with steep angles can last for a while but eventually correct to a more sustainable angle of 30-45 degrees. Trend lines are great for measuring the angle of the trend and the pace at which it is “moving”. Generally speaking, 3 types of trend lines are used:

  1. steep / inner
  2. medium / trend
  3. shallow / outer

When an inner trend line breaks the trend does not undergo a change because the price could easily stop at the medium trend line. But a break of the trend channel is the first serious clue of an upcoming reversal. More confirmation is needed for a potential trend to the opposite side, but the old trend at that point is out of the window. Once the outer trend line and support and resistance are broken, the old trend is for sure a thing of the past. Take some tie to learn forex trendline trading strategy in the link above.

4. Divergence

When the price is posting higher highs in an uptrend or lower lows in a downtrend, but the oscillator does not have higher highs or lower lows as well, then the currency pair has divergence. When the oscillator also has highs or lower lows then there is convergence. The oscillator is basically a measurement of momentum so when momentum does not confirm the trend there is less chance of a trend to successfully continue. Here is a quick good to guideline:

  1. Divergence – danger for trend
  2. Convergence – green light for trend

5. Change of our trend indicator (Not all of you will have this, but that’s OK)

For members, our Trend Indicator is a great way to get a head start on when the long-term trend may be changing. All you have to do is drag the Strike Trend Indicator onto ANY chart (even non StrikeTrader pairs) and choose which Time Frame you’d like to get a trend verification for

As an example, on the GBPUSD we have seen a major reversal. The Strike Trend indicator was able to catch this pretty quickly and those looking for longer-term trades would be in GREAT shape to short the market for several hundred pips after defining the trend change.

This is an easy way to spot potential turn-around in the market.
By combining all of these tips, we think you can really enhance your ability to analyze trend reversals in the market and take advantage of them effectively by using support and resistance, chart patterns, break of trendlines, divergence, or change of our trend indicator.

Thank you for reading!

Please leave a comment below if you have any questions about Practical Forex Tips!

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I use chart patterns most such as head and shoulders, inverted head and shoulders, double/tripple tops/, rising and falling wedges to recognise likely reversal of trends. A great article! Thanks Chris for sharing!

I use chart patterns most such as head and shoulders, inverted head and shoulders, double/tripple tops/, rising and falling wedges to recognise likely reversal of trends. A great article! Thanks Chris for sharing!

Thank you for the comment Osita! Chart patterns are great tools aren’t they ��

The images are missing…At least, on my computer.

Thanks for the heads-up. I also have the images as missing – although they were present last time I looked. I’ll sort it. Thanks!

images still missing

Thanks Zippy and Mihai, the images should now be working. Thanks for the headsup!

Charts showing ok me. I like the DTT for medium term confirms. When both sets line up there’s a solid signal reversal. Can be faster turns though if stock bouncing around like #2 #3. Then turn may not last as long as in #4 in a longer run up. Thanks guys, saving this one.

Hi Beergas, thank you for the comments. Great to read that the trend indicator is helping you with your trading. That’s awesome. Cheers!

see example 3., Trendline Breaks: Firstly, on 5 occasions the price hit the lower trendline and the trend was intact with 5x lower lows and 5x lower highs. On the 6th downward run, momentum faded and the price reversed long before hitting that lower trendline again. It then retraced back to the higher trendline – a very good signal that the momentum has faded and a reversal or at least a consolidation is imminent. *Note the ‘double bottom’ on that ‘reversal’ low – an indication of trend reversal in itself. 2ndly the price punched through the upper trend channel and kept going. 3rdly the price action made for a higher high. 4thly the price action came back down but this time made a higher low before going north again. A trend reversal has occured and a new uptrend is now underway. Incidentally, the pullbacks within this trend often retrace to close to a .618 or .764 fib level, then project back in line with the trend to a 1.27 fibonacci extension level. Generally good buy and sell zones. Note also, the higher timeframes especially weekly and monthly -outside of the intraday ‘noise’. A good policy to trade in that higher time frame trend direction – assuming there is a longer term trend easily visible. Heiken Ashi charts have some lag, but can make trading and seeing trends much easier than standard candlestix. Learn the candlestick meanings anyway. A pinbar in an extended trend is often a dead giveaway for a trend reversal, but all the trend reversal candletick patterns should be observed, especially around those levels and confluences mentioned below. Do some visual checks and backtests and see how often the above rings true. But watch the bigger picture and check larger time frame charts for past price action and major pivot points. Place horizontal support and resistance lines on your chart extending across from those levels. Note the Fibonacci levels and fib extensions from those last significant S&R and pivot point levels. And learn about the ‘confluence’ of multiples of those levels coming together for an even stronger potential reversal area. Note your momentum indicstors as you approach those levels. Keep an eye on the economic calendar for upcoming days. Find a good source of reliable forex news. Explore the apps for tablets too. Some very good stuff out there.

Thanks JodyP for your comments – much appreciated. Im sure traders will be happy to see the great advice, thank you.

hay howz it, im using the dynasty indicator and using the williams oscillator, i have found it pretty good but when dynasty is triggered and the arrow is long or short i enter and the market has gone the opposite way, why is this happening, cheerz alex,

Hey Alex, not sure if I can help, I dont know the dynasty indicator. Thanks for the comment!

i agree with you to use support and resistance combine with candlestick reversal formation and trade according to the trend. On the chart pattern most of the time you have to wait longer time for the pattern to form and you dont get a good price to trade because bigger stop losses. One more thing that i would like to add here and strongly suggest for traders to use in trading beside the above mentioned is Fibonacci.

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