In Day 13 of the 30 days to master part-time swing trading challenge I show you how to time trend reversals using volume analysis.
What is a Trend Reversal
Before we talk reversals, let’s talk about what exactly is a trend.
A trend is momentum or continuing price movement is a certain direction, be it up or down. Price tends to make higher lows and higher highs during an uptrend, while making lower lows and lower highs during down trends.
Trends can happen on any time frame, whether short, intermediate or long term. Day, swing and long term traders trade trends.
Trading trends are great for swing traders because the fact that there is a trend means price is moving. Thus, we can capture price movement in relatively short periods of time.
A trend reversal is a change in direction of the price trend. Essentially, momentum is reversed. At this point the fundamental structure of the price action has changed. The strategies once traded no longer work. This is the spot where many traders take on greater than necessary losses by not identifying the nature of the trend change and continuation to trade strategies that were working before.
Falling Knives, Tops and Bottoms
Anybody who has been in the trading game for more than a minute has heard one the antiquated cliches about trading trend reversals. Traders lacking a true understanding of the character of price and volume will say things like “you can’t catch a falling knife” or “never pick tops and bottoms”. They argue that reversals can’t be times and you can only trade the secondary move after that initial reversal. In fact, in many classic reversal setups like the “head and shoulders” pattern or double bottom, a big profitable chunk of the trade is spent sitting on your hands waiting for the overall pattern to form because of this fear of the reversal.
While these traders seek safety, I see missed gains. The irony is the potential profit I look to capture is “safer” because of the risk controls we put into place.
Why do these traders not trade the reversal?
They likely don’t understand the impact of volume on trends and reversals.
Volume’s Impact on Trend Reversal Setups
Now let’s refer back to the accumulation and distribution lesson from challenge 11 (review here). Remember strong up trends require a positive volume formation, while down trends require a negative formation. This is what we call accumulation and distribution.
Once volume starts to decline in an uptrend, we can expect some sort of consolidation, or even a pullback. This is a natural and healthy aspect of the trend. However, if volume starts to increase during the pullback, creating larger red candles relative to green candles, we have a sign that the uptrend is weakening.
The same type of volume action comes into play for the reversal of down trends, except this time we see expanding green candles, not red.
This is the type of volume action we often see at the end of trends that create tops and bottoms.
The Reversal Trade
Now let’s put what we have learned about volume and reversals into practice. In today’s video, I show you how we used volume analysis to predict a top in biotechnology ETF IBB, and a bottom in steel stock U.S. Steel. Once you have watched the video, make sure to do the exercise.
The Day 13 Exercise
- Take an index like the S&P 500 or the Russell 2000 and analyze stocks going back 5-10 years
- Take note of areas where the stock made big reversals, either in the form of tops or bottoms
- Now analyze the volume patterns before the reversals.
Previous Posts
Day 1: Getting Started
Day 2: Analyze the Market
Day 3: How to Use Moving Averages
Day 4: Managing Risk and Setting Stops
Day 5: Managing Risk on a Macro Level
Day 6: Managing Risk and Taking PROFITS
Day 7: The Reward to Risk Ratio
Day 8: Stochatic Indicator
Day 9: Case Study Webinar Replay
Day 10: 5 Keys To Trading With Volume
Day 11: Volume and Accumulation Distribution
Day 12: Volume and Trading Explosive Breakouts
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