Example of How to Trade a Reversal

When traders enter a reversal trade, they are expecting the pullback from the trend to be large enough for a swing trade, or even a trend in the opposite direction. The entry, protective stops, and profit taking are then the same as for any other swing or trend trade, and were discussed in the first two books. Since traders are expecting a large move, the probability of success is often 50 percent or less. In general, when risk is held constant, a larger potential reward usually means a smaller probability of success. This is because the edge in trading is always small, and if there was a high probability of success, traders would neutralize it quickly and it would disappear within a few bars, resulting in only a small profit. However, since a trend reversal trade may have a reward that is several times larger than the risk, it can have a profitable trader’s equation.

Trading a reversal is much more difficult than it appears when a trader looks at a chart at the end of the day. Once there has been a strong break of the trend line and then a reversal on the test of the trend’s extreme, a trader needs a strong signal bar. However, it usually comes in a very emotional market at a time when beginning traders are still thinking that the old trend is in effect. They also probably lost on several earlier countertrend trades in the day and don’t want to lose any more money. Their denial causes them to miss the early entry. They then wait to evaluate the strength of the follow-through. It is usually in the form of a large, fast spike made of several strong trend bars, forcing the traders to quickly decide whether to risk much more than they usually do. They often end up choosing to wait for a pullback. Even if they reduce their position size so that the dollar risk is the same as with any other trade, the thought of risking two or three times as many ticks frightens them. Entering on a pullback is difficult because every pullback begins with a minor reversal, and they are afraid that the pullback might be the resumption of the prior trend. They end up waiting until the day is almost over, and then finally decide that the new trend is clear; but now there is no more time left to place a trade. Trends do everything that they can to keep traders out, which is the only way they can keep traders chasing the market all day. When a setup is easy and clear, the move is usually a small, fast scalp. If the move is going to go a long way, it has to be unclear and difficult to take, to keep traders on the sidelines and force them to chase the trend.