Despite our best attempts at steering traders away from the reversal mindset and into a trend-following mindset, we still get traders that write to us asking about our thoughts on reversal strategies. In this blog post we will illustrate one simple observation that will at least allow you to be very selective about where you wait for a reversal setup to appear.
The caveat to this discussion is that most retail traders attempt to catch falling knives and sell into strong markets, and there is much “need to be right” behind this kind of trading.
But the markets do allow this kind of strategy and we will write more about it in the future. For now, here are some preliminary thoughts about being selective with your reversals.
Location, Location, Location
The first thing that will start to distinguish you from a common retail trader is selectivity. Pick your spots wisely and use a Daily chart (at least) for picking your spots. Using a daily chart allows you usually 3-8 hours of time before the market decides whether to rotate or continue. By using a weekly chart, you can wait for daily candle prints to deal you in. By using a monthly chart, you can use weekly or daily bars to deal you in.
The highlighted red and green zones represent evident daily swing points on the EURUSD in the past 3 months. They are further filtered with a momentum requirement that we’ll discuss futher down.
Do not pinpoint an exact level. Rather, the “wick” of the swing high or low is the broader zone you’ll be observing upon the market’s next visit. Broadly speaking, you want to see the same kind of reaction that the market demonstrated the first time it departed from the area (which ex-post became the swing high or low).
Here is what the hourly chart looks like:
And finally a current example, as the EurUsd is currently negotiating a previous swing zone. Some groups of traders will be watching this area for clues.
As noted earlier, only a few Daily swing levels were highlighted. They have been selected via a second filter: a momentum filter. Using a very short-term momentum measurement (4 days), we are ONLY looking for reversals when price is reaching a momentum extreme.
While not perfect, the idea is to zone in on those instances where price might be (temporarily) running out of gas. We have used our Momentum ATR indicator for this purpose, but a normal momentum indicator will tell you the same information in different format.
With the momentum indicator we are basically highlighting the instances when prices push beyond 1 ATR during the lookback period (4 days). Of course, these measurements are arbitrary and can be studied more in-depth.
The principle however seems sound: look at key areas the market reacted from in the past, and only deploy your setups when momentum is (possibly) exhausted and the market needs a pause.
Over to You
While extremely simple and preliminary, these considerations will already set you in a much better position than the typical retail trader that attempts to pick tops and bottoms at will.
Be selective (through daily/weekly/monthly swing areas), be patient (with the momentum filter) and be disciplined (don’t look for reversals anywhere else).
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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