Experienced traders believe that it is much more effective to trade in the direction of the trend and not against it. Surely many people have heard such expressions as “Trade with the trend” or “The trend is your friend” – there are many such instructions from experienced market participants. At the same time the desire to turn the market may be caused by just an opportunity to enter the market at the very beginning of the trend and with minimal risks. Therefore, the trader’s desire to buy at the low and sell at the high is also quite reasonable.
Again, one of the postulates of technical analysis says: “The current trend will continue until it changes its direction”, which pushes us to the fact that any trend will sooner or later end and there will be a change in the trend in the opposite direction. Such a trend reversal we will try to determine in this article.
What is a trend and where does it reverse?
A trend on the financial markets is a directional price movement. In theory, when we see a movement where every subsequent maximum is higher than the previous one and every subsequent minimum is higher than the previous one, we can say that the market is in an uptrend. At this point trends are trying to buy, because the current trend is more likely to last than to change its direction.
Consequently, if a bullish trend reversal is expected, it is important for us to make the next maximum lower than the previous one, and the new minimum will also be lower than the previous one. At this point we can assume that we are about to see a trend change in favor of the downtrend. Here it is important to think about selling the financial instrument.
If we see during the price movement that every subsequent minimum and maximum is lower than the previous one, then we are in a descending trend. If we talk about an attempted reversal of this trend, it is important to see the moment when the next minimum will not be updated, and the prices will break the maximum, it will be a simple signal of a potential reversal in favor of the uptrend.
As we can see, the very reversal of any trend is in the nature of price behavior in the market. However, traders rarely focus only on price movements, more often they add various tools for better detection of reversals.
Instruments for Detecting Trend Reversals
Experienced traders advise to look for trend reversal signals on daily charts. In general, you can try to do it on smaller time intervals, but it should be remembered that in this case the reversal is more likely to be short-term, because the main trend is better to determine on the daily chart.
The easiest way to determine the reversal is to break the trend line. If the trend is ascending, here we draw an ascending trend line using the minimum points and wait for the breakdown of this line. More often than not, the breakdown of such a trend line is followed by a return and a test from the opposite side, after which prices move further down.
In case of a downtrend, the line is plotted on the maximum points and it is important to wait for prices to fix above this line, so we can talk about the change of the downtrend in favor of a bullish trend.
The next variant is breakdown of the channel’s border. The construction of such channels is somewhat more complicated than a simple trend line, but the essence is similar to the breakdown of the line: here we wait for the price to go out of the channel, and at this point a trend reversal is formed. And many authors postpone the width of the channel in order to determine the potential for further price movement.
Chart traders also like to identify such moments with the help of trend reversal patterns. For example, “Head & Shoulders” or “Double Bottom” pattern, “Diamond” pattern can act as a reversal pattern. These are simple patterns, but there are some subtleties which are important to observe in their correct search and identification on charts, because only if used correctly they are able to give good reversal signals.
Will Moving Averages help?
Almost any trend indicator can be tuned to a specific instrument and try to look for the end of a trend. If we consider the moving averages, which are one of the best indicators to determine the trend on the market, of course they will also help with this task.
It is important to remember that moving averages will lag a lot. Therefore, we will get a signal to end the trend when another trend is in full swing. However, many investors think this is insignificant and if the new trend is strong, the part of the missed profit will be less than the potential profit from a good trend.
Moreover, this indicator will give signals in the direction of the trend, and we will be able to hold positions and add new ones as long as possible. There is also an opportunity to get a confirmation in the form of prices returning back to the moving averages after the start of a new trend. Such a return will give an opportunity to enter in the direction of the trend with less risk.
However, unfortunately, the Moving Lines are of no help in detecting a reversal at an early stage. On the other hand, they can tell us that the current trend is slowing down and losing its strength, the moment the lines begin to converge after a strong divergence. This we can easily notice and look for confirmation for the beginning of a trend reversal.
How to catch a reversal using patterns?
This is probably one of the best options for entering the market when a trend ends with minimal risk. If you, as a trader, like to analyze the chart and follow the price, then this method is perfect for you. Any of the presented patterns is able to give a good point of entry into the market when it is just forming, the whole risk of such a trade will be to enter as close as possible to the upper or lower point of the pattern.
If we’re talking about Double Top pattern, it’s important to enter the trade when the second resistance level is formed, and place the stop above this area. If the price moves in our direction, we can add a position when it breaks the support level, as the followers of classical technical analysis would have us do. In the case where the price continues to rise, we exit the market with minimal losses.
Here we need to be proficient with these tools and understand when to exit the market, if the prices go against us, because the trend in this case continues and the desire to wait out the current movement can result in huge losses.
At the same time, with the help of patterns we get an opportunity to enter the market at an early stage of the current trend’s end. This is one of the main advantages of graphical analysis. The nature of patterns formation and the market trend itself are closely related, and we react exactly to the price fluctuations, and not to the result of these movements processing, as in the case with indicators.
Divergence is a good signal for reversal
Alexander Elder singled out the “Divergence” signals on the MACD indicator as one of the strongest ways to reverse trends in technical analysis. Indeed, we can observe the strength of this signal on the daily charts, where such “Divergences” can provoke the development of serious corrections. Here it is also quite simple to enter the market: when the signal line leaves the histogram area, we sell, if the signal is formed above zero.
If the trend is downward and the signal is formed below zero, the signal line exit from the histogram area will be a signal to buy a financial instrument. However there are subtleties in using this method: we don’t always know where this signal may end up. Sometimes there are “Double Divergences” when the price moves even lower and the signal on the indicator remains relevant. In this case, we have to hold the position, but the risks of loss are greatly increased.
We can use simple technical analysis tools such as trend lines, channels and reversal patterns to determine the reversal, or we can add trend indicators, but get lagging signals. Several methods can be combined for a better result. For example, forming a “Divergence” on the MACD indicator and as a confirmation trader waits for a breakdown of the trend line, and only then enters against the main trend. Thus, we get already two signals to the end of the current trend, which significantly strengthens our position.