Trend Reversals – General Explanation and Requirements
This lesson will cover the following
- What do we mean by a “reversal”?
- Requirements for a reversal
Beginners should remember that trading against the underlying trend should not be initiated until after a key trend line has been breached. However, even in such a case, a trader should be cautious, because after the first move against the trend, the market actually continues to trend and attempts to test the old extreme level in the trend. And, as we already said, if the price does not succeed to surpass the prior extreme level, it has already made two failed attempts to do so, therefore, the market is more likely to take the opposite direction. So, a trader should look for entries against the trend, only after the test of the old extreme level.
What do we mean by a “reversal”?
A reversal during a trend may not necessarily be an actual reversal. It may stand for a transition between an uptrend and a downtrend and vice versa. It can be a transition between an uptrend or a downtrend and a trading range, a transition between a trading range and an uptrend or a downtrend, a mere breach of a trend line. The “new trend” may be restrained to only one bar. The price may move sideways for a few bars and then continue to trend either to the upside or to the downside.
Technical analysis experts will usually not mention the term “reversal” until a string of trending highs and lows has appeared. However, if a trader has begun to make entries in the direction against the underlying trend, he actually supposes that a reversal has taken place. In case a trader is going long during a downtrend, he supposes that the price will likely not go even one pip or tick lower. If that was not true, he/she would abstain from making long entries. As he/she is entering long positions with the belief that the price may move up, he/she actually supposes that the trend is now a bull one, thus, a reversal has occurred. Experts, however, would not approve such a statement, because the latter does not take into account some basic elements, proving the existence of a trend.
Requirements for a reversal
First, price movement needs to breach a key trend line from the previous trend. This is a strict requirement. And second, which is often observed but not strictly required, following the key trend line breach, the price returns and tests the extreme level of the prior trend.
A new trend has begun, if a series of higher highs and lows in an uptrend and lower highs and lows in a downtrend is already present. The first move will breach the key trend line, produce a pullback, which tests the end of the prior trend and after this test traders will probably make entries against the prior trend (respectively, in the direction of the new one). Sometimes this test may not exactly reach the old extreme. In other cases it may surpass it a bit.
Let us explain. If during a downtrend a sudden move to the upside occurs, which extends far beyond the bear trend line, the majority of traders will probably look for long entries on the first pullback in anticipation that this will be the first of many higher lows. At times the pullback may extend below the low of the downtrend, thus, it may trigger protective stops on the new long positions. In this case, if the lower low reverses up within several bars, this may produce a considerable move to the upside. If the lower low is quite distant compared to the previous low, it would be better for a trader to wait for another trend line breach, a strong surge and a pullback to a higher low or a lower low, before he/she initiates another long trade.
Despite the fact that most traders prefer to buy the first higher low in a new uptrend and sell the first lower high in a new downtrend, if the trend demonstrates strength, there will be a number of pullbacks and higher highs and lows (uptrend) or lower highs and lows (downtrend). Each of these pullbacks may be a good entry. The first higher low in the new uptrend can test the low of the prior trend (downtrend), or test a breakout from a previous swing point, from a trend line, from a trading range or from an exponential moving average. In the second case, the pullback may not approach too much the low of the prior trend (downtrend).