Further talk on trend reversals
This lesson will cover the following
- How do most trends usually end?
- Scalping against or going with the trend?
- The most reliable countertrend entry
How do most trends usually end?
As we said earlier in the guide, the majority of trends end with a breakout from a trend channel. An uptrend usually ends with one of the following two scenarios. First, there may be an overshoot of the bull trend channel line, a failure and then a reversal to the downside and a breach below the bull trend line. The second scenario involves a breach below the bull trend line without an overshoot of the bull trend channel line at first.
If an uptrend ends with a false breakout from the trend channel line, the market will usually demonstrate two legs down and the first pullback will very often reach a lower high, testing the high of the uptrend.
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If an uptrend ends with a breach of the bull trend line, the test of the trends high may lead either to a higher high, or to a lower high. A higher high will probably be followed by two legs down, while a lower high will probably be followed by one leg down, as the first down leg already appeared just before the formation of the lower high. If the market tests the prior extreme level with a higher high, a good trading opportunity is to go short on the first lower high (as it tests the higher high). In the case with a downtrend, following a lower low, a trader should go long on the first higher low, because this boosts the view that the major low has already been present.
Because trends may last for longer than one would anticipate, most reversal setups fail and the majority of continuation setups succeed. This explains why traders need to use extra caution when trading against the trend, based on reversal setups.
A trader, who draws a great number of trend channel lines, is probably anxious to detect a reversal, but, at the same time, he/she will likely miss lots of appropriate entries in the direction of the trend. What is also worth noting is that the majority of trend channel line overshoots and reversals are minor and not successful during an exceptionally strong trend. As a result, a trader would find himself/herself into many losing trades, if he/she entered against the trend. A better decision would be simply to wait for a breach of the trend line, before intending to trade against the trend, while considering all tiny trend channel line overshoots as setups for with trend entries.
Scalping against or going with the trend?
During a strong trend with little or no large pullbacks it is logical to start searching for small reversals. It is so, because the market will eventually pull back, when some traders begin taking partial gains and sufficient number of others, trading against the trend, open new positions. There is indeed a choice to be made – whether it is appropriate to scalp against the underlying trend, or whether to wait for the end of the pullback and after that enter in the direction of the trend.
In case the trend is indeed strong it is appropriate to enter against the trend, only if plain indications of a trend reversal are present (a breakout from a previous trend line, followed by a test, ending with a huge reversal bar. However, because some traders are quite eager to enter the market, they begin examining smaller time-frame charts (1-minute charts). The problem here is that these charts continue to visualize reversals as the underlying trend develops, while the majority of reversals usually fail. These traders presume that, as the 1-minute chart has small bars, entering against the trend would be accompanied by smaller risk, while if the entry appears to be on the peak of the market, the potential profit will be considerable. Having this in mind, they feel comfortable to take a few small losses. However, during the course of the trading session, the small losses increase in number and the cumulative result becomes a loss, which traders are unable to neutralize during the remainder of the day. The other possibility is, when these traders manage to position themselves at the end of the trend precisely. Now, using the 1-minute chart, they will manage to scalp actually a few pips or ticks of profit instead of holding the position for a larger move (something they have initially planned).
Let us have another example. A trader, using the 1-minute chart, sees an extended trend move and is very anxious to be in an active trade. In this case reversals on the 1-minute chart provide an opportunity to profit, by doing the opposite of what is apparent. A trader should wait for the reversal on the 1-minute chart to cause entries against the trend, but should not take these entries. Next, he/she will need to determine where to place the protective stop, if he/she had actually taken these trades. What he/she should practically do is to place a stop order in the direction of the trend at that exact price level. He/she will be stopped into a position in trends direction, while those trading against the trend will be stopped out. There will probably be no one to enter against the trend at this point and also not until the trend has developed further and another countertrend setup appears. This strategy is actually a high probability scalp in trends direction.
The most reliable countertrend entry
The only most reliable countertrend entry is to trade countertrend to a pullback (as the pullback represents a small trend in the opposite direction of the main trend). As soon as pullback traders have ended their domination in the market and trend traders have taken back control by breaching the trend line, which contained the pullback, every small pullback, that occurs from this point on, testing the trend line breakout, is a good opportunity to enter the market. This entry is opposite to the pullbacks direction and in the direction of the major trend. What is more, it may lead to at least a test of the extreme level in the main trend.