I do call myself a reversal trader but most people do not understand that every new trend starts with a reversal.
A reversal trader should, thus, probably be called “early trend” trader and conventional trend-following trading then becomes “late trend trading”. In the end, it doesn’t really matter what you call it, but it’s important to know the differences between the trading styles and where your edge lies. Reversal traders need to focus on those, what I call, “transition points” where the market rolls over and goes from uptrend to downtrend, or vice versa.
Transition points often follow the same rhythm and after trading them for years, they are super easy to spot. Careful, it doesn’t mean that they are easy to trade but you can follow a few very specific tips to improve your trading.
So in this article I want to talk a little bit about transition points and using filters in your trading. In our pro area, you’ll then learn the exact steps to finding and entering such trades, where your stop and target goes and how to manage trades. Plus, you will learn a variety of different setups to help prepare you for different market conditions.
Head and Shoulders
My favorite pattern is the Head and Shoulders. At the same time, it’s very difficult to trade because many traders follow it and the market often shows “squeezes” or fakeouts around Head and Shoulders. It’s, therefore, very important to understand what a good Head and Shoulders pattern looks like. The thing that most traders overlook is the power of “waiting”. In our trading we use “filters” to keep us out of trades and in the context of the Head and Shoulders, the final filter is the break of the neckline. Here is a great example of a recent move.
Trendlines are my second favorite tool and the example below shows a recent trade example where markets went from uptrend to downtrend after a trendline break after completing a Fibonacci sequence.
My bread and butter trade
Below is the basic reversal trade which makes up most of my trades and the EUR/AUD was great recent trade many of our pro members also took. In this setup we use a moving average with support and resistance to determine the transition point where the market turns from one direction into the next.
3 tips for finding a transition point
As you can see on the trade recaps above, finding transition points can help you find great trades and catch new trades very early on.
Transition points also act as natural filters and keep us out of bad or low probability trades. A filter is usually a final entry criteria and in this example we use neckline breaks, trendline shifts, moving average crossovers or momentum changes as filters. See, most traders make the mistake of entering trades too early and those filter criteria keep us out of trades often. In our pro area, that’s what our new trader need to learn at first: wait for a little more confirmation and don’t trade until we have our transition point with our filter criteria. Sounds complicated? It isn’t…
Let me give you 3 quick and easy tips how you can find transition points in your trading:
1. Momentum changes
It all starts here and looking at pure price action is always the first starting point for any good analysis. When I look at a chart and a trend, I look at the distribution between bullish and bearish candles and I ask myself: Do we have more bullish or bearish bars? Has the ratio changed recently? Which bars are stronger: bulls or bears? Does it look like price is running out of steam or even showing early reversal signs.
The screenshot below shows a recent NZDJPY trade where the market went from strong uptrend (almost no bearish bars), to a range with a double top, to a downtrend. The change in momentum was first obvious when price showed strong bearish candles, when the double top held and then when price started to make lower highs. The transition point was the break of the support line.
Further reading: How to understand momentum – momo trading guide
2.Head and Shoulders
When I find a Head and Shoulders, I look at the way the head and the shoulders are forming. Especially the right shoulder is important and if it shows us a significantly lower low, it can be a big market tell, compared to a head and Shoulders where the right shoulder is barely lower. Then, I set my price alert at the neckline and I wait for a strong break.
The inverse head and shoulders below is a good example and the right shoulder shows a higher low, breaking the trend structure. Once we break above the trendline and the resistance, we have our transition point.
A trendline is only valid if we have at least 3 touch points. Furthermore, I only look for trendlines after long and strong trends because the longer a trend, the higher the likelihood that it will turn into a completely new trend. Weak trends tend to wiggle down into consolidations and not provide good reversal opportunities. The most important thing about trendlines is to wait for three confirmation points AND a strong break of the trendline.
The lesson is this: understand the idea of your trading method, which market type you trade and then implement filter criteria that keep you away from low probability trades and only allow you to get into the best trades.