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Reversal Trading

Big Idea: Reversal trading is when traders try to trade a change in direction in a market. If a stock or a currency pair is moving up, there will always be traders looking to trade the downside. Catching a reversal is a very alluring thing to achieve, and most traders out there want to trade the counter-trend. What you may notice over your span of analyzing markets is that most retail investors look to short the uptrend and long the downtrend. There is a common saying that “the trend is your friend”, and oftentimes, that is true. Usually, when the price of something has been declining for a long time, institutional money is selling at the same time. And when the price is going up, big money is probably buying too. Here are some examples of a successful and a failed reversal:

Example

The picture above shows price making a lower low which suggests that a downtrend has begun. However, price clearly bounces off lows and continues its uptrend. This chart is an example of a pullback. Understanding the difference between pullbacks and reversals are important in both longing and shorting markets. Although it is difficult to spot and catch a true reversal for most investors, smart reversal traders will cushion themselves with proper risk management.

This is an example of a true reversal. You can see the price in a clear uptrend before long red candles take it down to several lower lows. What makes trading reversals so appealing is the potential extreme gains one could make in a short period of time, even though it doesn’t happen too often. Additionally, reversals of this magnitude need to come with other factors involved with technicals. This example was when the US declared a full economic shutdown back in the March crash of 2020.

Key Takeaways

-A reversal is a change from one direction to another

-Lots of retail traders try to go against the trend looking for reversals

-It’s difficult to spot a reversal early, and smart traders use good risk management

-True reversals are often coupled with other fundamental factors

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