4 Steps to Profit from Reversal Trades
By Jason Love, OilTradingGroup.com
Catching a falling knife, standing in front of a speeding train, buy low and sell high, these are just a few of the terms used (some flattering, others not) to describe the art of trading reversals. If successfully identified and executed, it can be one of the most lucrative trades that exist. But the key is how to identify, with consistency, those areas where price action is likely to change course.
I am going to share with you the process I go through to identify those trades that have the best chances for success.
Step 1: Identify the Big Picture Trend
As a guy who runs a live trade room, I am often asked “why are you trying to buy dips, when the market is clearly in a bear run?” This common question is often asked by a trader who is only utilizing a single time-frame to make a trading decision. Let me explain.
In the chart listed below, this market is in a classic bear trend; lower moves low and lower moves high.
Figure 1: 1-Minute CL Chart
However, what is missing in this chart is a bigger picture perspective to truly identify the higher time frame trend. What you can see in the chart listed below is really the 1-minute chart (shown above) is simply a smaller pullback in a higher time-frame bull move.
Figure 2 60-Minute CL Chart
So, in order to properly identify a reversal trade, it is important to identify the higher time frame trend in order to execute a proper reversal strategy. I am a day trader and as such, I don’t hold positions past the close each day. My “higher” time frame chart is going to be different than that of a swing trader or a buy and hold trader. Simply put, you will need to identify the type of trader that you are and apply the appropriate higher time frame chart. For me, the higher time frame is a 60-minute chart.
In the chart example listed below, I am looking at a 60-minute chart to identify the underlying trend.
Step 2: Identify potential Supply & Demand Zone (Support and Resistance)
Once you have identified the direction of the market on your higher time frame, you then want to begin to identify possible areas of pullback on this higher time frame chart. The objective of this is to identify areas of possible reversal (trading opportunities) to get into sync with the trend.
As you can see there is a possible pullback area that is 56 ticks wide. Also, the top of the bearish trend channel can provide additional confirmation.
Additionally, you can use fib retracement levels to add confluence to your prediction of a possible reversal point. The standard 61.8% and 78.6% levels along with the non-traditional 70.5% (shown in red).
Step 3: Get Reversal Signal on Higher Time Frame
Ok, so before we start to trade the reversal, you will need to look to identify that the reversal has started on your higher time frame chart. In the example chart listed below, you can see that we identified a potential resistance area, measured out the possible retracement point and now we have a candlestick formation as confirmation.
Step 4: Find the lower time frame entry location
I don’t trade on a 60-minute chart; I like to look at the smaller time frame chart for entry opportunity. In this case I will look to the 15-minute chart for entry opportunities.
Trading reversals is not easy nor is it for the faint of heart. You must be patient and wait for the opportunity to set up properly. The following rules can be used for proper reversal trade setups.
- Find the trend on the higher time frame.
- Look for areas of support and resistance that can provide a turning point.
- Wait for the turn to occur on the higher time frame. Use the confluence of indicators or price action to let you know the turn is beginning.
- Divergence in your oscillator (RSI, Stochastics) or Momentum indicators like the MACD.
- Overbought / Oversold conditions.
- Fib retracement patterns.
- Candlestick formation(s).
- Shift to the lower time frame for confirmation. You are looking for a break in structure.
- Enter the Trade.
- Set your profit and targets based upon your risk / reward profile.
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