The basic action plan for a counter trend strategy is: –
- Identify a support or resistance level in a trend
- Figure how best to enter at that level
- Identify the point at which we know the support or resistance has failed
- Determine a reasonable target
- From the target and failure levels, make sure that the bet is viable, with a reasonable risk-return ratio
- Wait for your signal, and make your bet
- Adjust your stop loss as the reversal continues
- Watch for and act on your exit signal when the reversal slows or finishes.
The previous section covered the most widely used strategy, that of assuming and betting that a trend will continue. As this is what it does most of the time – it’s practically the definition of a trend – it is a high probability way of trading. But it’s still a matter of timing. Trends do run out of steam and stall or even reverse, and that gives another set of strategies for traders who want to take out a bet on that.
If you have read through the technical analysis section (and I’m assuming you have because there’s little point looking at a trading plan until you understand how the markets move), you will have seen that there are a lot of indicators and patterns whose main purpose is to show that the market sentiment and the trend is changing. The various pointers towards a reversal include seeing when technical indicators “diverge” or are telling you something different to the price chart; many candlestick patterns supplement indicators and give you a trigger; and the price approaching a strong support or resistance level which has held, in other words reversed the trend, in the past.
Some of the easiest reversals to spot are the ones that take advantage of established support or resistance levels. It’s true that support and resistance do not hold for ever, but what you are really looking for is the likely bet, and you can always take it a little later, after the reversal has shown itself, if you are nervous.
It depends how tried and tested the levels are as to how safe or likely the reversal is to happen. In some ways the more evident the reversal is to other traders, the safer it is. In this sense it is almost self fulfilling – if others think that a falling price will shortly bounce and start increasing, then they are thinking that buying it would be a good thing – and if they buy it will probably push the price back up by supply and demand. The same applies when the price meets resistance, except they will be looking for short positions.
You need to look for the number of times the support or resistance level has held, and how recently. Look for increasing volume, showing that other market participants are paying attention. If the reversal is in line with the long-term trend, it is more likely to succeed.
Don’t forget to look for the role reversal that support and resistance lines can take. Just because one of these lines is eventually broken, it does not mean that it has no further part to play in the way the price moves.
It has been said before, and must be understood – when you decide to use candlestick patterns to help in your trading, you must also check conventional indicators to see that the market is ready for what they are telling you. Steve Nison is the recognized expert in this field, and that is one of his golden rules – he was a fully fledged technical trader before he happened across candlestick patterns and his life changed.
Just to go over some other points with candles –
- The pattern requires not only the necessary candle(s), but also a preceding trend – you can’t reverse a sideways move!
- Even with a candle pattern, you should only bet when the market justifies it – such as the next day opening and closing lower, after a bearish doji.
- Candles don’t give price targets, for that you need conventional technical analysis.
- Don’t try and remember or use them all, concentrate on a few good probability ones, such as the engulfing patterns and the stars.
Another indication of a potential reversal is when the price does one thing, and the indicator does another. This sets up a tension in the market which must be resolved, usually fairly quickly. It is relatively simple to set up stock screens to test for a “divergence” like this, and put forward suitable candidates for your review.
Divergence is also useful to indicate that a trend is weakening and likely to end, but in this context we are looking for a reversal from the analysis. A reversal is simply a trend that hasn’t become obvious or confirmed yet, so you must take due care to see that the reversal is really going to happen before entering your bet.