Selling on Weakness: Reversal Trading

Reversal Trading or Contrarian Trading as it is sometimes referred to is one common tactic employed by spread traders. With this trading strategy, traders seek to find points on a chart where an uptrend or downtrend appears overextended and likely to reverse direction. Such traders will look for potential ‘buy’ trade entries when they spot that a downtrend is showing signs of a reversal (and moving larger) and ‘sell’ trade entries when an uptrend is approaching the finale for the upside (prepared to turn lower).

Again, this trading strategy is the opposite of the previous strategy. It is well known in trading circles that markets tend to fall three times faster than they rise and with a good trading strategy in place you can profit from such short but sharp sell-offs when fear has grabbed investors’ perceptions. Here we will evaluate a couple of short selling strategies available to a trader to maximize your gains on the down swings.

One strategy revolves around spotting short term downtrends by seeking shares that are reaching lower highs. Here we aren’t looking to trade on the first lower high, but wait for the second lower high to take a short position. In such scenarios there is a good chance for a stock to fall even lower and form a lower low, thus giving the trader a good risk-reward play. Off the second lower high your goal is to get the entry timing right by checking the stochastic indicator to be marking an overbought condition hinting further short-term weakness in the share price. This trading strategy is commonly referred to as reversal trading since you are looking to take a short position whilst the share you are monitoring is recovering in price but still forming a lower high. Chances are that in such setups the difference between support and resistance levels or recent highs to recent lows is likely to provide good opportunities to trade and profit on the short side.

Some traders are attracted to shorting stocks following bad news or or when a company’s stock price has rallied upwards too fast – so they open up a down bet in the expectation of a pullback. Of course in such situations you would need to be prepared to get out quickly if necessary.

Another idea is to find a really poorly performing stock, which is doing even worse than the poorly performing market sector that it is in, and to take out a short trade to ride the price down while the trend lasts. There is no sensitive market timing using this strategy, unlike many other systems. What you are doing is joining in on an established trend.

Once again, this strategy is best used for stocks, because then you can compare the individual stock performance to the sector and the market and make sure it is the worst performer you can find. As you are able to spread bet on several different stock exchanges in different countries, even if your domestic stock market is not in a downtrend, you may well find one in another country which is not performing well.

Once you have found a down trending market, you should look at the different sectors in that market and pick one that is performing more poorly in comparison to the others. Within that market sector, you now have to choose a stock which is trending down even faster than the sector, by say 2% for the past few weeks. Basically, this process of going down through the levels is designed to find one of the worst performing stocks for the trade.

As stated above, with this strategy you do not have to wait for an entry point but just take out a short position as soon as you have selected your stock. The trade will fail if the stock starts rising, so you position your stop loss just higher than the recent highest level. You can exit your trade using a trailing stop, or take your profit when there are signs that the downtrend is losing its momentum, for example if the stock is no longer performing worse than the sector.

When short selling it is important to know when to liquidate your position and its often a good idea to run stops to limit your financial losses should the market move against you. When a share you are trading comes under pressure and start to fall investors may become nervous and sell which can lead to an avalanche of selling, providing sharp traders with great trading opportunities on the short selling side. However, the reverse also holds true and when a market is sold off, speculators may get in quickly to buy back the share if they see value (fear/greed). Thus, it is important to be alert when trailing stops and locking gains since you need to be aggressive for these shorting trading strategies to work effectively.

Some traders hesitate to use reversal techniques preferring trend trading instead but there are some benefits inherent to this trading style that aren’t possible with other strategies. It is true that predicting reversals is a lot more tricky to determine than continuing trends, but a reversal strategy permits traders to get in early into trades which is quite the opposite to what happens with trend following. As such a contrarian approach can allow much better entry trade levels and substantially bigger payouts when productive.