I am a pure mean reversion and reversal trader which means that I look for clues that an ongoing trend is losing momentum and potentially reversing into the opposite direction. However, reversal trading can quickly become a very dangerous trading approach and it can be very risky if traders don’t know how to separate good from bad reversals.
In this article, I explain the 4 different types of market tops and the most important principles of reversal trading.
The trading edge – what does it really mean?
Knowing exactly when you have an edge is one of the key components of good trading. Whereas most amateur traders think that they have to be in the market at all times, the professionals understand that they have to pick their battles wisely.
Over the years of trading one setup exclusively, I have come to known my edge very intimately and I understand that I have to stay out of the markets 95% of the time because I don’t understand what is going on. However, when my edge presents itself and I see the market conditions that my setup is built around, I know exactly how to position myself and there are no doubts or hesitations anymore.
The 4 types of market tops
Once you start looking into trading reversals, you’ll quickly start to see that most market tops look very similar and when we boil it down, we find that 99% of all reversal points can be described by one of the four market structures. Then it becomes fairly simple to develop an edge around reversal trading.
Preamble – when we look for reversals
Before we get into the 4 market tops, let me briefly explain what I am looking for in a potential reversal trade. A successful reversal is much more likely after price has been trending for some time. This means that I only look for reversal trades in Forex pairs that are in a strong trend, have pulled away from the 20 SMA substantially and haven’t broken the 20 SMA for quite some time.
Further reading: My screening process for reversal trades
1) The consolidation top
Let’s start with the most common market top and the one that is the most challenging. When trading reversals, it’s important to understand that not all trends completely reverse into the opposite direction. Although seeing a trend reverse with a clean swing into the opposite direction would be the ideal scenario, it’s much more common that a trend enters a sideways consolidation after a trend.
At the same time, those consolidation tops often start out as promising reversal trades but then quickly lose momentum and just drift sideways. Here it’s important to cut your trade fast and minimize the loss potential and acknowledge that those are not tradable.
Optimal entry: There are two entry possibilities on the chart above. The first is the initial break of the 20 SMA which, considering the strong momentum break at the SMA, was a decent signal. The second entry was after the double top and again broke the SMA in a strong way.
Exit: The exit after the first trade was tricky but most traders would have probably held on to the trade too long and realized a loss once price broke back above the SMA. For the second entry, targeting the prior low would have made sense and although it’s not a complete trend reversal, it’s a safe and easy trade.
Important: Don’t hang on to a trade too long. When you are trading reversals you don’t want to see that price moves back into a loss after you have been in profits because it clearly shows a lack of “follow-through” momentum.
2) The parabolic top – V top
The second most challenging type of tops and bottoms are the V tops/bottoms. Traders lose the most on those market tops when they try to catch those rapid movements.
When it comes to controlled reversal trading, the V tops and bottoms should be avoided. Those setups don’t offer high probability setups, but many amateur traders get easily sucked into those types of fast moving and high volatility price patterns.
Optimal entry: Again, the best entry is after a strong break around the 20 SMA.
Important: Although the screenshot above shows a successful V top, you’ll often see very fast turnarounds after price breaks the 20 SMA and then price immediately heads for your stop loss. I don’t suggest trading V tops, but if you still do it, be quick on the exit and trail your stop conservatively.
3) Swing top
The swing top is my preferred reversal pattern as it’s a very obvious pattern. At the same time, it challenges the psychology of traders a lot which makes it fun and interesting to trade. As the name suggests, a swing top is characterized by multiple swings and here the difficulties start for many.
A trend with only 1 trend wave is NOT enough for me to get interested into trading a reversal; a reversal trade after trend with only 1 wave has a MUCH lower probability of succeeding. At the same time, don’t get too fixed on only looking for 3-wave reversal patterns if you are an Elliot Wave fan. In my experience, and after trading hundreds of those reversals, there is no reason why 3 should be considered ‘the best wave count’; you’ll just as often find reversals after 2, 4 or 5 waves.
Next, the swing top is challenging the FOMO (Fear of Missing Out) of traders. With every swing, traders believe that a reversal is just around the corner and then they get too excited and enter too early just to see price make a new wave. FOMO is the greatest danger when trading the swing top.
Optimal entry: During a swing top, price usually retests the 20 SMA multiple times. It is, thus, even more important to wait for a CONFIRMED and STRONG break of the SMA. Stay away from making mid-candle decisions and also candles that barely break the SMA.
Exit: When trading the swing top, I usually always set my targets ahead of support/resistance levels. It’s advisable to scale out slowly and use the 20 SMA (plus some padding) to trail your stop loss.
Important: The swing top often comes in the form of a Head and Shoulders pattern and such a top can often lead to a major trend reversal.
4) Grinding top
This is my second favorite pattern and it’s one that often gets overlooked because people don’t see it as a classic reversal pattern. Once you start paying attention, you’ll see that this pattern is very common. The grinding top often occurs after very strong and impulsive trends and it has probably a lot to do with the way traders view such market situations.
After a strong rally, the ones that missed the move will be desperate to enter for a continuation whereas the ones that are in profits are looking to exit and realize their win. The grinding top feels very good for the people who enter too late because they can see that price keeps going without a lot of volatility; they are lulled into a comfortable and dangerous position. Before the reversal happens, you often get an impulsive move higher (squeeze) and the late trend-following entries suddenly have larger profits. A few minutes later, price reverses completely and squeezes the longs out of their trades which means accelerated selling.
Optimal entry: The optimal entry usually always looks the same for the grinding top: after a spike to the upside (often through the Bollinger Bands®), price sells-off strong and breaks the SMA. When you see a trendline at the lows, this can help you time your entry even better.
Exit: Grinding tops often lead to very strong and impulsive reversals which, as we saw on the V top, can whipsaw just as fast as well. Similarly to the swing top, it’s the safest option to take profits at the first major support/resistance zones and then let the trade run with carefully trailing the stop behind the SMA.
There is nothing special about trading reversal the way I trade them and even if you don’t trade reversals, I have an important message for you:
The power of focusing on trading one setup only will transform your trading beyond what you think is possible. Once you eliminate all the distractions and only pick one pattern, you’ll quickly start noticing all the nuances and clues around that pattern. By only focusing on one setup only (and I mean becoming obsessed about it), you will quickly become an expert and you will be amazed by your progress. There is nothing so powerful as ditching all the noise around you and the markets and achieving mastery in one field.