The ChoosaBroker Trading Academy
11.2. Understanding Trends and Spotting Reversals
For more than a century, the focal point of technical analysis has been what traders call “trend.” This seemingly complex concept may appear intimidating at first. However, knowing a few basic principles that lay at its core is more than sufficient to create a profitable trading strategy.
What is Trend?
In simple terms, an underlying asset’s trend is the broad direction in which its price is moving. Prices very seldom move in straight lines. They move in wave like patterns that chart distinct price peaks (highs) and price troughs (lows).
Uptrends are characterized prices plotting consecutively higher price peaks and higher price troughs.
AAPL Chart From 15/02/2014 – 15/03/2015
2. Down Trend
Down trends are defined as a series of successively lower price peaks and lower price troughs.
EURUSD Chart From 01/09/2014 – 15/11/2014
3. Sideways Trend
A sideways trend is said to exist when an underlying asset’s price remains stuck within a broad horizontal range.
GBPUSD Chart From 03/05/2018 – 16/05/2018
How to Structure a Trade after Identifying a Trend?
One of the most important lessons that traders need to learn before they enter the market is to never fight a trend. Entering in to trades against the broad market trend is like trying to catch a falling knife. Shorting a market that is strongly trending higher is a low probability trade. It may work sometimes, but will more often than not result in a loss. Similarly, initiating longs in a down trending market with the hope of “catching the bottom,” is a short cut to failure.
A simple yet widely applied strategy to “flow” with the trend is to patiently wait for a contra-trend move on a lower time-frame chart, and then enter at the first sign of the pullback exhausting. Let us look at the below example to better understand this strategy. On the monthly chart, gold is in a primary down trend as is signalled by the series of lower price peaks (swing highs) and lower price troughs (swing lows).
We next switch to the weekly time-frame to zero in on a secondary price bounce-back within the primary down trend. As soon as the counter-trend rally runs out of steam, we enter short. This is confirmed when the last major swing low fails to hold on the weekly time-frame chart.
Gold Price Chart From 01/08/2012 – 15/05/2016
Gold Price Chart From 01/01/2014 – 31/12/2015
What are Trend Reversals and How to Detect Them?
A trend reversal is defined as a change in the broad direction in which an underlying asset’s price is moving. The proliferation of online charting platforms has resulted in the availability of a large number of fancy studies and indicators to detect changes in trend. We, however, will stick to the time-tested approach of simply tracking price action.
An uptrend is deemed to have potentially reversed to a down trend if the series of higher price peaks and higher price troughs gets disrupted, and is followed by price charting a lower price peak and a lower price trough.
A down trend is said to have likely reversed to an uptrend if the series of lower price peaks and lower price troughs gets broken, and is followed by price plotting a higher price peak and a higher price trough.
USDJPY Chart From 01/11/2017 – 20/02/2018
How to Profitably Trade Trend Reversals?
To successfully trade a reversal in an underlying asset’s trend, you will need a precise market entry point and a stop loss area to limit risk in case the reversal turns out to be false. For a reversal from a down trend, traders should wait for price to make a distinct higher peak followed by a higher trough. Long positions can be initiated on a close above the first higher peak, with the protective stop placed just under the last major price trough.
USDCHF Chart From 01/09/2013 – 15/10/2014
In case of a change from uptrend to downtrend, short positions can be initiated on a breach below the first lower price trough, with the protective stop loss placed above the last major price peak
USDCHF Chart From 15/07/2016 – 15/08/2017
Final Few Thoughts
Successful trading is 80% patience and 20% execution. To profitably trade both trend reversal and continuation, you have to be okay with watching your market setups slowly unfold while you sit on the sidelines and wait for the perfect moment to jump in.