How to Know When a Trend Reversal Is Likely
We have all heard the phrase, "the trend is your friend" and as traders we also know just how amazing profitable it can be trading alongside it as well as how devastating it can be to out accounts when we trade against it. But before we are truly able to spot likely trend reversals, we must be able to spot a trend itself.
There are three types of trends:
An uptrend occurs when the price is making overall higher swing highs and higher swing lows.
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Again, though, we need confirmation.
A downtrend happens when the price is making overall lower swing highs and lower swing lows.
The Sideways or Horizontal Trend
Sideways or horizontal trends come into play when there is very little movement up or down within the chart giving traders no clear sign of where future prices are going.
In addition to their direction, trends can be further classified in terms of their length. Traders like to consider trends within short-term, intermediate-term and long-term categories.
- Long-term trends occur over a time-frame of longer than one year
- Intermediate-term trends occur over one to three months
- Short-term trends occur over less than one month
When analyzing trends, it’s important to take into consideration the time-frame the trend represents to best reflect the type of trend being analyzed. Daily or weekly charts are best for identifying long-term trends, while minute or hourly charts are best for short-term trends. It is also important to remember that long-term trends carry greater weight than short-term trends. For instance, a one-month trend isn’t as significant as a five-year trend.
Trading with the trend is by far the most important concept in technical analysis with a trend being really nothing more than that of the general direction in which a security or market is moving.
Now that we clearly understand what trends lets look at three sure tells that the trend will most likely reverse.
SIMPLE MOVING AVERAGES
Trend traders often turn to Simple Moving Averages to cut out all the daily spikes and drops to find reversals setups with an intermediate to long-term moving average.
As trends form on a variety of time-frames, I personally like to use the 20-day, 50-day and 200-day Moving Averages to single out short-term, intermediate-term and long-term trends. When they start to line up, like the weekly chart of Disney (DIS) seen above, I have found its a good time to think about getting ready to execute a trade.
If you are just starting out, you might want to consider just using the 20-day & 50-day moving average to tracking shorter term trends.
MOVING AVERAGE CONVERGENCE DIVERGENCE (MACD)
As the trend under question begins to build momentum, two of the moving averages will also diverge, and as a trend begins to lose steam, the two moving averages will converge. For traders looking to judge the strength of a trend, the MACD can be used for finding price divergences. This price divergence is in many cases a strong signal the the trend is likely to reverse.
VOLUME SPIKES & DROPS
Massive changes in volume can be a another strong indicator that the trend is beginning to lose steam and may have run its course. This happens when greedy buyers begin to bail out for profits, or new buyers and bottom-feeders begin to pick up shares after a stock price has fallen significantly.
You can easily spot extreme volume bars on a chart, but I would personally recommend playing around with Bollinger Bands applied on volume data.
Last but not least, massive volume changes can also help better define more reliable key levels of both support and resistance enabling us to further determine whether a trend reversal is likely to occur.
As traders and investors, we all know nothing is ever a sure thing. Instead of entering a full position, we should start by testing the waters with a smaller position then loading up once the reversal has be confirmed.
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