I love reversals. They are some of the most profitable setups in trading and they are extremely powerful when you can spot and trade the right ones.
Nothing in the universe can go on forever. Everything that rises must eventually fall (although the opposite is not always true).
A stock that has been going higher, higher, higher as if a jetpack is attached to its back will eventually start losing steam and begin the slow and sometimes fast and dramatic descend back for a pullback or a sell-off.
If you can spot that sweet spot of a reversal soon enough then you are in for a treat.
90% of my very best traders over the last three decades have been reversal trades. It is my bread and butter.
With all this reversal trading I have learned some important rules through some tough trial and error ( a lot of error).
I call them my golden rules of reversal trading and I will briefly explain them to you in this post. Here we go.
1. Stocks fall faster than they rise
That is a fact that has been statistically proven time and time again. People feel fear much more than they feel joy. When a stock falls it signals fear. It creates a cascading effect.
The stock reaches a high price so people sell to take profit so the stock falls a little. Other traders see the stock falling so they start selling as well. The stock falls more, faster and faster. More traders see this and sell as well, the stock falls much faster and so on.
In the beginning, traders sold to book profits but later on other trader sold to prevent a loss or to avoid an even larger loss.
Lesson here: you are better off shorting a reversal to the downside because the move will be faster and more dramatic.
2. The S/R level is more important the first couple of times it is tested
S/R means Support/Resistance.
The S/R level that is tested more than 2 times becomes worthless for me. That’s because we can see that traders have tried breaking it several times in the past so the chances that they will succeed this time around are much higher.
I like to trade only the first two times the price comes to an important S/R level. The third and subsequent times I skip it, always.
3. If an uptrend reaches a peak on low volume then this is a strong sign of reversal
When you see the volume fizzling out as the stock makes new highs it’s about the strongest signal you can get that buying is cooling down and sellers will start winning very soon.
Trading is an auction. If one side starts giving up then naturally the other side will start winning.
If buyers stop buying then sellers will drive the price lower as they try to find buyers to sell to at lower prices.
The opposite is not true however for downtrends because they can continue falling on low volume. I’m generally more comfortable shorting stocks on highs that I am buying stocks on lows.
Downtrending stocks are low energy, on both sides. They are unpredictable, boring and dangerous.
4. If a set up doesn’t work exit right away
When you are in a trade you should constantly ask yourself this question. If were to buy this stock right now, would the current set up meet my criteria?
If the answer is no then there is no reason for you to still be in this trade. Just because you are in it already is no reason for you to continue being in it if the situation has gotten unfavorable. It’s time to take your loss and exit before things get out of hand.
These are my four golden rules for reversal trading. I like to keep things simple, as you may know, dear reader so I tried to do that here too. No sense blabbing on about them. They are clear enough. I hope you will remember them when you trade reversals.