While trading in the middle of a trend is fine, trading near the reversal provides a way to jump in on moves just as momentum is building. This often means a high probability trade because those who were betting on the old trend continuing are forced out of their positions, resulting in a surge in the new trending direction. Of course no method of trading works all the time, but trading reversals can be profitable….if you know what to look for. In this article we’ll look at downtrend reversals (into uptrend). In the next article we’ll look at uptrends reversing (into downtrends).
A downtrend is in place when the price is making lower swing lows and lower swing highs. Which highs and lows you focus on will be determined by your trading style. Very short term traders may want to focus on every high and low which will make for lots of trades. Traders looking to trade less will only focus on major highs and lows.
Downtrends are reversed by either the price making a new high followed by a higher low, or a higher low followed by another rally. If a downtrend is lower lows and lower highs, when the prior mentioned conditions develop, it indicates a reversal.
Here is an example of a downtrend being reversed via a higher low.
In the chart above the price is moving in an overall downtrend on the left–lower overall highs and lower overall lows.
The price makes a higher low in March. As soon as we see that higher low we draw a trendline on the price wave that created that created that higher low (yellow downward sloping line). We buy when the price rallies above that trendline. The higher low followed by the move higher (above the trendline) provides us with a signal that the downtrend is at minimum in trouble, and could reverse.
If trading traditional markets place a stop loss below the recent low. The trade can be short-term to just catch initial upside momentum, or longer-term to capture the potential bigger trend reversal (should it arise).
The other type of reversal we can have is when the price rallies aggressively enough to erase the former wave of the downtrend; a higher high is created. Following the higher high, wait for a pullback you can draw a trendline on. Assuming the price makes a higher low (higher than the major low which started the aggressive rally), buy when the price breaks above the pullback trendline. If trading traditional markets, place a stop below the recent low.
The trade can be short-term to catch initial upside momentum, or longer-term to capture the potential bigger trend reversal (should it arise).
These are simple ways to trade downtrend reversals based solely on price action. The method requires that a trendline be drawn on a pullback. If the pullback is very small or very sharp a trendline can’t be drawn, and therefore no signal will be provided. Therefore the method won’t be tradable on every reversal.
Not every signal will result in a reversal, the former trend could resume at any time. This means we need to constantly analyze price action to see when signals in the opposite direction occur.
A profitable exit will depend on whether you want a short-term or longer-term trade. For a short-term trade look to exit within a few bars of the entry bar; you just want to capture the initial momentum. For a longer-term trade you will need to give the market enough time to begin trending in your direction (at least one higher high and higher low) before considering for an exit.