Reversal trading strategy helps a trader to make profits from the reversal of a market trend. Reversal trading aims to determine a potential reversal signal so that traders can exit their positions.
If you are a new trader, you may be wondering how to trade and whether or not it’s even worth it. After all, the world of trading can seem pretty overwhelming, especially when considering all the different strategies.
But don’t worry—once you get your feet wet with trading, you’ll find it easier than you think! Reversal trading is one of the easiest trading strategies. What makes reversal trading so easy is that you only have to identify when an asset is about to change its direction of the trend and then buy or sell accordingly.
Reversal trading is based on the idea that when an asset’s price increases or decreases to a certain degree, it will change direction and move in the opposite direction. A reversal is usually a temporary change in the direction of prices. The reversal trading strategy can be used on any timeframes and with any instruments to calculate the movements.
Trend Reversal in Financial Markets
When an asset’s price moves up or down for an extended period, it will eventually reach a point where buyers or sellers are over-extended and cannot drive the price higher or lower any further. This causes the price to show a trend reversal in the financial markets, which creates a lucrative opportunity for traders who anticipate it.
For example, traders would buy if an asset’s price rises during a reversal. In contrast, if the price is falling, traders would sell during a reversal. This concept can be applied to both short-term and long-term trading strategies.
The first step in a reversal trade is to identify whether a market is trending and in which direction. You can plot moving averages on your chart or use the Average Directional Index.
Whichever method you use for reversal trades, it’s essential to confirm whether the price is making a sequence of higher jumps lows (in an uptrend) or lower highs and lows (within a downtrend). Once you’ve established a trend, it’s time to search for potential reversal points. These are areas where price has stalled previously, i.e., resistance levels in uptrends or support levels in downtrends.
Resistance occurs when a market’s price moves up into an area of supply, while support occurs when the price moves down into an area of demand. As such, resistance and support levels are key areas where we should expect reversal trades taking place. You can identify these areas using technical analysis indicators by plotting supply and demand zones on your charts.
The best way to do this is to look for multiple indicators that support each other. The reversal strategy uses technical analysis techniques (that a chart shows) to identify a potential reversal trade at key support and resistance levels. These points are determined by analyzing previous highs and lows of an asset’s prices and various technical indicators that display how the marketplace shifts are happening.
What is Reversal?
A reversal is a change in the direction of the price trend of the different financial assets. Reversals occur when a trend stops rising or falling and begins moving in the opposite direction. Trends do not move in one specific direction forever – they change direction momentarily and can continue moving in their original direction. In trading, reversal patterns determine when a price trend will reverse.
A potential reversal trade occurs when the price of an asset moves in one direction and then quickly changes course to move in the opposite direction. Traders often use this reversal trade pattern to indicate that a trend may reverse and that it’s time to buy or sell.
For example, if the price of gold has been increasing over the last few weeks, a trader might think this trend will continue and use trade reversal taking place as an opportunity to make a profit by selling at high prices. Still, if gold suddenly starts falling again, it could indicate that there will soon be another reversal in favour of buyers.
The concept of reversal is familiar to many traders: it is the idea that once a prevailing trend reaches a point of exhaustion, it reverses direction. On the other hand, the concept of continuation refers to the idea that, after an already-established trend reaches a point of temporary stasis or consolidation, it continues in its initial direction.
The great thing about reversal trading is that it’s relatively easy to spot these trends and make decisions. However, remember that no strategy has a 100% success rate—some assets will continue their current directions despite what they look like they will do next!
Sometimes even a popular opinion trending in the market may have an impact on the investment strategies to use.
Reversals and continuations are both important concepts for investors making short-term trades and those who trade long-term; indeed, many traders rely on these concepts to predict the direction of the market and make informed decisions about what positions to take.
Reversal trades are also useful for long-term investors who want to know how much they should invest over time instead of just buying something today hoping it’ll go up tomorrow; if prices keep going down after you’ve invested heavily already (and haven’t sold yet), then you’ll have lost money on your initial investment.
In long-term trading, investors can leverage their knowledge of reversal trades to understand better which companies’ stocks will perform well and which ones won’t. They can then invest accordingly, buying shares from the good companies and selling their shares from the bad ones. Day traders also need reversal information to decide how many times per day they should trade stocks (and which ones).
How to Use a Reversal? (Example)
If you’re an active trader, you know that the market is prone to sudden reversals—and as a result, you may be looking for ways to navigate these crashes and make money no matter what. One way to do this is to use a trade reversal. A trade reversal is a process of buying and selling contracts in quick succession to take advantage of large swings in the price of an asset.
A trader can use this strategy to protect against the effects of a crash by reversing their position and taking a short position. This is usually done when the expected return from a market crash is more than it would cost to reverse the position. The most common time to reverse trade is after a market crash and before it recovers.
We will look at an example using the NSE as our base asset. For instance, we are long on the NSE at INR 2,000 per share, and we want to use our short position on the NSE futures contract to protect against a downfall within the index.
The futures financial contract currently deals at INR 2,000 per share and was seen climbing steadily during the last months. We believe in a good chance of further fall in the NSE’s futures contract due to macroeconomic elements like interest rates and inflation.
We decide to buy back our long position on the NSE futures contract and take a short position on the index instead. By doing this, we have reversed our position and are now profiting.
Difference between a Reversal and a Pullback
When it comes to investing in the stock market, there are two main ways to return your investment: reversals and pullbacks. While they share some similarities, they also have some key differences.
The key difference between a reversal and a pullback is that reversals occur on a long-term basis, while pullbacks occur on a short-term basis.
Reversals are an indication that the overall trend of an asset is changing course, and pullbacks are a temporary decline in price against the existing trend.
A trend reversal is a long-term change in the direction you expect a stock to go in. For example, if you think a stock will go up and it starts to go down instead, that would be considered a reversal. On the other hand, if you think a stock will go down and start to go up instead, that would also be considered a reversal.
In contrast, a pullback is a short-term deviation from the expected investment trend. For example, suppose you believe that overall stock will go up and temporarily down. In that case, this is considered a pullback—not a reversal—as long as it eventually starts trending back upward again.
Pullbacks can last from weeks to months; if one lasts longer than six months, it is typically considered a reversal instead of just a pullback.
Pullbacks can be considered a type of reversal. But in financial terms, pullbacks describe a much shorter time frame—just days or even hours. They’re often caused by investors trying to lock in their gains from recent bullishness. Still, they can also indicate that the market is feeling overbought and needs a breather before moving higher again.
Bottomline
The reversal trading strategy takes the guesswork of trading by using stock charts to help you determine what trades to make. This strategy involves analyzing charts to find stocks that are likely to reverse course after a long downtrend or uptrend. It’s beneficial for people who want an easy way of identifying good trades without spending too much time on research!
