In simple terms, a trend reversal is a change in the price direction of an asset. A reversal can occur to either the upside or the downside. Following an uptrend, a reversal would be to the downside, and following a downtrend, a reversal would be to the upside.
As you can see in the picture below, in an uptrend, the price moves up forming higher highs (HH), and higher lows (HL). Once the price starts to lose its upward momentum, at some point it will eventually start to form lower highs (LH) and lower lows (LL) relative to its last points. At that point, the trend is no longer an uptrend; thus, a trend reversal has occurred. The same is true for a downtrend, in which the price starts forming HH and HL to shape a trend reversal.
A trendline is a straight line that connects more than 2 low or high points (over-pivot highs or under-pivot lows), making a path for the continuation of the trend while acting as either support or resistance for the price.
They show the direction and speed of price, and also describe patterns during periods of price contraction. Breaking the trendline is often a mildly strong signal for trend reversal.
A pullback happens after a trendline is broken, and the price oftentimes attempts to retest the broken line one more time. It is important to note that a trend reversal might look similar to a pullback; however, a reversal keeps going further and forms a new trend, while a pullback ends and then the price starts moving back in the trending direction.
Furthermore, you will need at least one LOW and one HIGH point to be certain that it is a reversal. Therefore, in an uptrend, if the price sets a LL followed by a HH, it is still an uptrend, and vice-versa.
Moving Average Convergence/Divergence (MACD)
To understand MACD, first, we need to clarify what convergences and divergences mean in trading. Divergence is when the price of an asset is moving in the opposite direction of a technical indicator, such as an oscillator like MACD, or is moving contrary to other data. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction (trend reversal). Convergence happens when the price of an asset and an indicator move toward each other, thus, convergence is not a concern for a futures trader.
To make it easy to understand, I will break it down to the most practical points that I personally use in MACD. When the price of an asset goes up, and the bars on the MACD go down, a negative divergence is taking place, which indicates underlying weakness. This means the bulls are exhausted and a trend reversal is due.
The opposite is also true. Sometimes the price forms lower lows, while the oscillator forms higher lows. This indicates an underlying strength and a weakness of the bears. In this case, a trend reversal from a downtrend to an uptrend is possible, hence the reason this is called a positive divergence. Also, MACD’s signalers trigger technical signals when the MACD line (blue) crosses above the signal line (orange) to buy or falls below it to sell.
ON BALANCE VOLUME (OBV)
OBV is an indicator that uses volume flow to show momentum and predict price changes. In other words, it resembles the sentiment of the market to foresee a bullish or bearish outcome. When volume increases sharply without a significant change in the asset’s price, the price will eventually jump upward or fall downward. In my experience, OBV is much more useful than the typical volume histograms that you can commonly see at the bottom of price charts because you can get far more signals by comparing the relative action between price bars and the OBV.
This indicator can help us see where the smart money is headed. As big players begin to buy an asset that the retail is selling, the volume may go high but the price will stay relatively the same. In the end, the volume will drive the price upward, and at that point, the whales begin to sell, and the retail begins buying. The way it works is that when both the price and OBV make HH and HL, the uptrend is likely to continue. The same is true for a downtrend.
However, in a trading range, if OBV is rising but the price is stable, accumulation is taking place, which is an indicator of an upward breakout. And if OBV is falling but the price is stable, distribution is the underlying cause, which indicates an upcoming downward breakout. When the price goes up but OBV makes LL, a negative divergence is taking place, and if the price goes down while OBV makes HH, a positive divergence is at hand.
HIGHER HIGH FORMATION AFTER A LOWER LOW
As briefly explained before, a trend reversal will take place when peaks and troughs change their previous formation. In a downtrend, you will typically expect to see a LH and LL formation. With the price losing its downward momentum, there will eventually be a “last” LL, after which we will see higher highs and higher lows. It is premature to assume that we can always predict the last LL, however, with the reversal in hand, we can always find other suitable entries on the next higher lows.
The idea is to enter a long position on a HL and to sell on a HH. The same is obviously true for short positions. It is always logical to enter positions following the trend. So, if we are in an uptrend, we enter long positions on HL’s, and if we are in a downtrend, we enter short positions on LH’s.
To sum up, trend reversals are one of, if not the best triggers to enter both long and short positions. To optimize the best results, it is important to learn different formations and practice a great amount of time on charts to see where and when reversals are more common. Combining all the techniques mentioned in this article can greatly affect your win ratio.
Indicators are a great help; however, a trader must never fully rely on tools. It is also important to point out that all of these triggers would mean nothing if the trader is not experienced and is making decisions based on FOMO and stress. In my next article, I will touch upon the other side of trading, namely the psychology of trade.