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Reversal Trading Explained 

Last Updated: March 16, 2021

By Rayner Teo

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In today’s episode, you’ll discover the truth about reversal trading and how to trade it like a pro.

So tune in right now…

Resources

The Essential Guide To Reversal Chart Patterns

The Trend Reversal Trading Strategy Guide

Price Action Trading: 6 Things To Look For Before You Place A Trade

The Complete Guide to ATR Indicator

How to Use Trailing Stop Loss (5 Powerful Techniques That Work)

Transcript

Hey, hey, what’s up my friends? In today’s episode, it’s all about reversal trading.

What is reversal trading?

As a reversal trader, you are in essence a counter-trend trader who’s trading against the trend or the current momentum.

For example, let’s say the market is in an uptrend, making a series of higher highs and higher lows. As a reversal trader, you’ll look to sell in that uptrend. Or for example, if the market is in a downtrend, then as a reversal trader, you’re looking to buy in that downtrend.

How not to be a reversal trader

Yes, as a reversal trader, you’re trading against the trend and the momentum. But it doesn’t mean that you should try to catch a falling knife. Let’s say the market is dropping every day, you don’t want to blindly enter a trade just because you’re a reversal trader looking to buy low and sell high.

That’s foolish because if you are buying into the lows, there’s no logical place for you to set your stop loss plus there are no signs that the downtrend could be ending soon.

How to be a reversal trader

As a reversal trader, you want to be smart about when you enter your trades and there are a few things I want you to pay attention to.

1. You must have a reference point on your chart

What is a reference point? Let’s say the market is in an uptrend, breaking up new highs every single day, and then there’s a strong sell-off or a strong pullback in the market over the next 2, 3 days.

If you look left of the chart, you’ll now have that swing high as a reference point on your chart. That’s the first thing you need as a reversal trader—you want to identify a reference point on your chart.

2. Wait for the market to retest that reference point

Let’s after the market has sold off and is starting to climb its way back up higher in the uptrend over the next few days, and then it retests that reference point. The next thing that you’re looking for is for the price to retest that reference point and to get strongly rejected.

So instead of breaking out higher, it reverses and closes lower for the day. What this tells you is that the buyers tried to break out of the reference point of the swing high but failed to do so.

There’s no follow-through—there’s not enough momentum and buying pressure to push the price up higher. What happened next is that short sellers came into the market and buyers also took profit in the market quickly, so the price reversed back and closed lower for the day.

This is what in essence a false breakout where the price tried to breakout higher but failed. That’s why it’s called a false breakout. That false breakout will serve as a reference point.

3. You can now set a proper stop loss

With that false breakout, you can now set your stop loss above the highs of the false breakout. Compare this to earlier where you don’t have a reference point, you don’t have a false breakout. There’s no logical level on your chart to set your stop loss.

But now that you have your reference point, now that you have a false breakout, you can simply set your stop loss above the highs of the false breakout candle, maybe 1 ATR above it.

Let’s say the false breakout’s high is at $100. You can set your stop loss at $105. Give it some buffer. If you want to define objectively how much buffer to use, you can use the ATR indicator.

ATR stands for average true range, which measures the volatility of the market. And you’re simply adding the ATR value to the high of the candle.

4. Set a conservative profit target

Next thing once you have your stop loss in place, which is above the highs of the reference point, above the highs of the false breakout, the next thing is that if the market moves in your favour, where do you take profits?

Remember, as a reversal trader, you’re not trying to ride the entire new trend in the opposite direction, because most often what happens is that you get a pullback, and then the trend continues to head higher.

As a reversal trader, you want to be smart about it, you don’t want to be greedy. My suggestion is to be conservative with your take profit level. You want to take profit possibly at the nearest swing low.

This is an area on your chart where potential buying pressure could come in and push the price higher. If you’re selling at the referenced highs, you got a good entry, don’t be greedy with your take profit level—be conservative.

You can target at the nearest swing low and just capture one swing in the trade. And that’s it. And that’s the goal of reversal trade, to just capture that one swing in the market, and just let it be.

Of course, some of you want to be more aggressive in the sense that you want to try and ride a new trend when the market reverses.

Again, be smart about it. Don’t use your full position and try to ride the trend. What you want to do is that instead of maybe using a full position and pray that you catch the reversal.

What you can do is to take 50% of your position off the table may be at the nearest swing low and leave the remaining 50% of your position on to see whether the market does reverse completely and move into your intended direction.

Even if it doesn’t, at least you’ve booked some profits and you could still end up with a small winner on the trade.

So be smart about it and don’t try to think that you are going to catch the full reversal. Trust me, more often than not, it’s a pullback and then the trend continues higher. Be smart and conservative when it comes to taking profits.

Let’s do a quick recap.

Recap

  1. Don’t try to catch a falling knife nor sell into a parabolic move
  2. Instead, look for a reference point on the chart
  3. Look for a false breakout at the reference point
  4. Set your stop loss just above or below that reference point
  5. Be conservative in your profit targets because the trend more often than not will just continue in its intended direction

With that said, I wish you good luck and good trading. I will talk to you soon.

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