Four Specific Steps for Trading Successful Trend Reversals
By Corey Rosenbloom, Afraid To Trade
Success as a trader does not come down to predicting the future with 100% accuracy. Instead, it's a result of consistently identifying - and trading - high probability opportunities that risk a small amount of capital for the potential of a larger gain, usually a multiple of the capital risked. The goal thus becomes identifying opportunities with a higher probability of returning the reward (profit) than the loss that would occur on a predetermined stop-loss. While there are dozens, if not hundreds, of low-risk, high reward opportunities, I wanted to focus your attention on one of my favorite set-ups that fulfills these criterion: low-risk, high-reward, greater chance of a successful outcome.
In general, strategies that take advantage of trends in motion - "pro-trend strategies" - test out better than anti-trend strategies that fight a trend. While reversal or "fade" strategies may have their place in a trader's toolbox, new traders often do best by focusing on simple strategies that capitalize on a price trend in motion.
One of the best strategies a new and developing trader can employ is a simple retracement strategy. Retracements take advantage of a trend in motion by generating a buy signal as price "pulls back" or retraces to a support level during an ongoing trend. Once a trend is in motion, odds tend to favor continuation of the trend as opposed to reversal. While it's tempting to expect a trend to reverse, data and trading experience do not back up reversal strategies as the best approach, especially for new traders. While there is only one actual reversal spot in a trend, there are often plenty of opportunities to buy pullbacks or retracements during the development and continuation of a trend in motion.
Momentum precedes price, and this pro-trend retracement set-up is based on that principle.
We must FIRST observe a clear New Momentum High as well as a New Price High (or Low, in terms of the Impulse Sell), and then note that as our INITIAL CONDITION. Once we observe these TWO variables occur simultaneously, we WAIT PATIENTLY for a pull-back (retracement) in price, usually to the 20-Period or 50-Period Exponential Moving Average.
Once price has made a new momentum high, pulled back to the rising 20 (or sometimes 50) period moving average, we then wait for the TRIGGER which will pull us into the market for a type of “Swing” trade or “Scalp” trade where we play for a RETEST ONLY of the previously established price high.
Figure 1: Amazon.com (AMZN) showing two new price highs confirmed with new momentum highs.
In the chart of Amazon.com (AMZN) above, we see two examples of the "New Price High with New Momentum High" condition. We're using the standard Rate of Change (RoC) indicator which is available on most charting platforms. While it's easy to spot a new price high in an ongoing trend, we must look for a new indicator high in the momentum oscillator to confirm the new price high. In real-time, compare the value of the indicator to the previous peaks during the uptrend in price. If price - in an uptrend - makes a new high, we look for confirmation from momentum as it also makes a new indicator high along with price. It helps to draw a vertical line connecting the price high with the momentum high. Note the two highlighted examples in the uptrend of Amazon.com (AMZN) during 2013.
In addition to momentum (the RoC Indicator) making a new high along with price, you can look to Volume to confirm a new price high as well.
Note the spike or increase in volume at the same time Amazon.com (AMZN) shares pushed to new swing highs during an ongoing uptrend. These occurred at the same time the new momentum highs occurred.
Figure 2: Amazon.com (AMZN) in an uptrend. New Price Highs are also confirmed with spikes or increases in Volume.
If momentum precedes price, then a new momentum high (identified in a momentum oscillator) should lead to a new price high more times than it leads to a new price low. This is the ‘greater than 65% win’ condition that allows us to quantify this set-up, and it allows us a framework to place and manage a trade.
We do not enter at the new momentum high, because odds then shift to favor a swift retracement against that new price high as profit takers sell positions and aggressive, but unaware, traders establish short-sell trades, diminishing demand and increasing supply.
We wait for a retracement because we expect price to swing back upwards and at least retest the most recently established price high.
We play for a small target, and play for a RETEST of the NEW HIGH ONLY, rather than trying to ‘get greedy’ and play for an entire ‘swing leg’ up in price (which often will unfold). Often, price will swing above the most recent price high, and it is perfectly fine to leave at least half of the position on to play for the new price high, but research shows that the greatest odds LONG TERM will come from playing for the retest of the high ONLY.
The Tools You Will Need:
For spotting and trading the "Impulse Buy" specific retracement set-up, you'll need to use a price chart of bars or candles (I prefer candle charts but simple bar charts are sufficient).
20 Period Exponential Moving Average:
A short-term moving average. Look for a steadily rising 20 period EMA as a bullish uptrend continues. EMAs can be used to confirm trends in motion and to enter a trade at a pullback to a rising average. In a strong trend, price will pull back (retrace) only to the rising 20 period EMA and then "bounce-back" or rally up off this average. We want to position our trade with low risk in the event that buyers do step in and rally this price up off this potential support level (think of it like a self-adjusting, rising trendline).
50 Period Exponential Moving Average:
An intermediate term moving average. Similarly, the 50-period EMA should be rising during an uptrend in price. A steeper pullback may find support at the rising 50 EMA, but we generally prefer taking trades into the rising 20 EMA. The 50 EMA is often a good indicator to use as a stop-loss level, placing a stop-loss under the 50 EMA and trailing the stop higher as the 50 EMA trends higher. While the 50 EMA can be an entry trigger to buy, it's often best used as a level for which to trail a stop. Think of it as the "last line" of defense for buyers to enter and "bounce" the market up off support.
A Momentum Oscillator:
There are many ways to measure "Momentum" in the market. Keep in mind that "Momentum" is a concept and not necessarily an exact trigger as would be the case for a cross-over trigger (like an indicator crossing above or beneath a zero-line). We look to the momentum oscillator as confirmation only, not a trigger for entry. The standard Rate of Change (RoC) indicator is accessible to traders through most charting platforms or websites. The default period is 14.
Indicators such as the 3/10 MACD Oscillator, indicator named "Momentum," and other advanced indicators may be used as you develop experience with this concept and want to move beyond the basics.
Price MUST make a new high and momentum must make a new high for the Impulse Buy Trade.
For the Impulse Sell Trade, Price must make a new LOW and momentum must make a new LOW.
We wait for the retracement to the rising (or falling) 20 period exponential moving average, and then when price ‘hits’ this area, we establish a position either at the market, or with a limit stop order to take us into the market (long or short) when price reaches this level.
Alternatively, you could wait for price to test the rising 20 period moving average and wait for an “Up-Bar” or “Up-Day” before establishing your position. You could also demand that the ‘Up-Bar’ take out the price by at least one penny of the last one or two candlesticks or bars, to give you greater confidence that the upswing is occurring.
There is a window of entry in this trade. If you enter BEFORE price tests the rising 20 period moving average, you would be entering aggressively, which is fine because sometimes price does not touch the moving average exactly, as many traders will by scurrying to buy (or short-sell) at this zone. You may actually make more money in the long-term doing this, because you would be getting in early, but sometimes the price may collapse through the moving average, leaving you with a loss that wouldn’t have occurred had you waited for confirmation.
If you enter AFTER price tests the rising 20 period moving average, your win rate will likely be higher but you will make less money because you will be entering fewer trades and capturing a smaller piece of the eventual price action. Here is a real-time example: two touches of the rising 20 day EMA and thus two BUY trade entries in Amazon.com (AMZN):
Figure 3: Amazon.com (AMZN) demonstrates a New Price High, New Momentum High, and Spike in Volume in late October 2013. Traders had two opportunities to BUY as price retraced and touched the rising 20 day EMA in November. The simple price target was the prior high near $370.00 per share.
Again, it is tempting to play for a ‘whole new leg’ or ‘entire swing’ in price, but odds favor that price will at least retest the most recent price high or low. Odds drop off when playing for a target beyond the most recent price high. The longer a swing in price endures, the greater the odds are for a reversal. By exiting before we expect price to peak, we not only lock in a profit, but we are “Selling” when others are clamoring to “Buy” because they just can’t stand sitting on the sidelines any longer. You will sometimes incur ‘negative slippage,’ meaning that if a move is strong and you place a sell-stop order out there, you might get filled at a level higher than you anticipated (which is exactly the opposite when you are selling when everyone is buying, or vice versa).
We will allow price to trail slightly below the rising or falling 20 period moving average, in order for the market makers to ‘play games’ and take out the weak stops that cluster predictably beneath key levels of support and resistance. Generally, you want to place your stop at least one ATR (Average True Range) value beneath the exact value of the 20 period moving average, provided that number is not a ‘round number’ such as $43.00 or $33.50. If so, go a ‘strange number’ below that zone, such as $42.91 or $33.44, to give yourself room to avoid a slight break under the exact level.
With stops in positive-expectancy trades, it is best to allow ‘wiggle room’ and not place stops too conservatively. With these trades, your profit target is defined by the price structure, so you want your stop to be ideally at least one-third of your profit target. For example, if you are playing for a $6 target, place your stop around $2, given what the daily Average True Range is for the stock. It is sometimes best to give yourself TWO average true ranges for a stop value, but no more. If you are playing for a $10 target, perhaps a $3.30 stop beneath the moving average is best, but you can definitely decrease that to $2.00 or so. This is where your own personality and experience comes in to grant you freedom in where you place stops – be it aggressively (larger stops further away) or conservatively (smaller stops closer to entry).
As mentioned earlier, traders may also choose simplicity and trail a stop under the rising 50 period EMA, assuming that if price does break under the rising 20 EMA, it will stop and reverse up away from the rising 50 EMA. If price breaks firmly under the rising 50 EMA, odds shift to favor a reversal and we would indeed need to limit losses in this "reversal" outcome.
The following are examples of textbook Impulse Buy Trades:
Figure 4: CME Group (CME) Daily Chart. Uptrend in motion. New Price AND New Momentum High in early November 2014. WAIT for the pullback (retracement) to the rising 20 day EMA. The trigger is into the rising 20 EMA (near $83.00) and first target is the prior price high near $86.00 per share. As the uptrend continued, price traded even higher than the target.
The initial condition (#1) occurs when price is uptrending and pushes to a new swing high. The condition for our "Impulse Buy" Trade develops when Momentum - and preferably volume - spike to a new indicator high on the chart which acts as a confirmation of the new price high. Notice that September 2014 saw a new price high but NOT a new momentum high (look closely at the August 2014 momentum high). Once we observe a new price high confirmed with momentum, we want to enter on the first pullback to the rising 20 EMA. This occurs in mid-November 2014 toward the $84.00 per share level. Our stop-loss is placed - and trailed - under the rising 50 day EMA (blue in the chart above). Notice how in this example price does trade slightly under the 20 EMA but NOT under the 50 EMA - that's where we want our stop. It's ok if price doesn't instantly bounce up off the 20 day EMA.
Finally, our Target (#3) is simply the prior swing high which occurred near $86.00 per share. As mentioned, you can exit the full position here as price touches the target, or if you're more aggressive, you can take profits on half of your position and hold half until price breaks under a reversal candle or on the first "down" day or sell-candle (bar) on the chart.
Yahoo! (YHOO) reveals two Impulse Buy retracement set-ups during an uptrend in 2013:
(Figure 5: Yahoo! YHOO Demonstrating Two Impulse Buy Trades in 2013)
The Impulse Buy Trade has a clear rhythm: Initial Condition, Retracement, Buy, Stop-Loss Placement, Target.
The initial condition is a new price high occurring in an ongoing uptrend in price. We then look to momentum to confirm a new price high with a new indicator (momentum) high and if so, we have our initial condition. We then wait for price to pull back (retrace) to the rising 20 day EMA and then buy as price touches the 20 EMA. Our stop-loss is then placed and trailed under the rising 50 period EMA and then we wait. Either price will break lower, causing a failed trade and a stop-loss trigger outcome (small stop) or else buyers will enter at a low-risk pivot level, causing price to rally up at least as high as the prior swing high and then likely beyond that. As traders, we simply want to be clear with our entries, management, and exit and capture the high-probability swing. The stop is smaller than the distance to the target which is the prior swing high. The key is patience and being objective with these parameters.
The "Impulse Buy" Trade is a special type of pro-trend retracement opportunity that relies on an initial condition to generate an entry, target, and stop-loss level for us to trade. Depending on the distance of the retracement, the stop will often be two or three times the distance to the target (prior price high). With that logic, we have a small risk at the same time we have a larger profit target.
Our rules help us stay on the right side of probability and thus limit our losses when price fails to reverse up off the moving averages. Not every trade can be perfect, but the key is finding higher probability outcomes that allow for a small risk (distance from entry to your stop) at the same time it offers a larger profit potential (distance from entry to your pre-defined target).
The Impulse Buy Trade is just one of the many specific trade set-ups we teach and employ daily at Afraid to Trade, WATCH THE VIDEO HERE for more details on how you can fill 5 gaps in your trading.
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- Lesson 1: Specifically, How do Trends Develop and How Do We Identify Them?
- Lesson 2: What Indicators are Best for Trend Trading Tactics?
- Lesson 3: How to Take Advantage of Trends through the Perfect Pullback Strategy (Set-up, Entry, and Targets)
- Lesson 4: When to STOP Trading With the Trend When it is Showing Signs of Reversal (and What are Those Signs?)
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