Now we are beginning our study of various trading signals. In this chapter, I am going to explain some of my most favorite signals- Trend Reversal (TR) signals. In subsequent chapters, I will show you some Trend Continuation (TC) and Sideways trading signals. In the end, we will look at some chart based powerful signals that can be easily identified on price charts.
Trend Reversal signals are powerful signals and offer attractive trading opportunities. They offer big profit potential with a close stop-loss. So when a trend reversal signal explained in this book is right, it is likely to result into a large profit. However, when it fails, the position can be closed with a small loss. The signals I use usually catch most of the trend reversals and the changes in market moods. When a signal takes place after a long trend, it usually points to a major primary trend reversal. We will call such instance as a Strong Form of the signal. However if it takes place after a trend of few days, say 4 to 20 days, or has some conditions fulfilled in a weak fashion, it should be usually taken as pointing to the beginning or an end of Reactions/Corrections. I will refer to it as Weak Form of the signal.
Most ordinary investors/traders use 'gut feelings' when looking for a trend to reverse. If the price of a stock has come down significantly over some time period, people start seeing 'value' in it. They expect the decline to stop soon. On the other hand, if a stock has gone up too high too rapidly, people take it as an overpriced stock and they expect its price to drop. I guess such situations offer traders high level of confidence and comfort. This is because one is buying something cheap for which many investors might have paid a high price just few days ago! As such, there is nothing wrong with this strategy. It is widely used by value-oriented investment managers. However for a trader, there is quite a mismatch between his objectives and Value strategy. Sometimes a stock that has just dropped in value might be just getting out of favor, and it may take weeks if not months for it to regain its lost glory! Hence I strongly recommend a trader to control his emotions or desire to call a stock's price too high or too low. He should stay away from predicting trend reversals just based on a large drop or sudden rise in price. When a stock is going up, it is going up because other investors/traders are willing to pay higher price for it. They might have information that most other traders may not be aware of! When a stock is going up, it is because buyers are willing to pay higher prices than what sellers are willing to sell at. This shows strength- a strong demand. In such situation, instead of guessing when sellers will gain power and cause the price to drop, it makes sense to ride the train than standing in front of the locomotive! If a person finds the price too high or too low, he may want to abstain from taking a position. However for taking short or long positions contrary to the current trend, he should use some formal indicators or signals.
A trader should keep two things in mind: A TREND IS A FRIEND, and TRENDS ARE LIKE CRAZY RIVERS. It is easier to swim with a trend than against it. So unless a trend reversal signal discussed in this chapter or some other method objectively indicates a trend reversal, one should resist every temptation to call the current price of a stock the Bottom or the Top just based on some 'gut feelings'. When one is looking at the price of a stock, it is never too expensive or too cheap. To know if it is expensive or cheap, one has to know its value. For finding value, one needs more than just the prices - the company, its products, management, industry outlook, competitors, -the list is endless. Then to determine if it is expensive or it is cheap, 'value' is compared to its price. This is more than just listening to the prices! As I have mentioned earlier in this book, for profit in stock trading all that is needed is just the current stock prices. Watching a stock move; and, if various conditions are fulfilled, acting on the trading signal by taking, or closing, a position is all one needs to be doing. Valuations are good for a long-term investor. They are good for an institutional manager who has to convince his boss that he is doing right things. For a trader who is riding a stock for a few days, valuations do not matter much. What matters most is the changes in demand and supply for the stock.
There are many trend reversal indicators in use, like ROC, MACD, Moving Averages, %Williams, etc. They fall in two classes - leading or lagging indicators. The problem with leading indicators is that they fail quite often. An ROC or RSI indicator may stay in oversold position for weeks and months before the stock price starts climbing up. On the other hand, lagging indicators are sometimes too late for trading! The Profit from Prices method and signals based on prices overcome those problems. This method gives signals on the day the stock is changing its course and they do this by looking at changes in underlying demand and supply. The advantage is - one can exploit the significant part of the impending new trend and that too with a small, calculated risk. The signals we are going to learn shortly have potential for Big Gain at a Small Risk, which essential for most traders to maximize their overall profit.
Every trend reversal signal in this chapter will be discussed for two opposite trends. First, I will show how to apply it in a bear market (downtrend) to capture trend reversal from a bearish (down-) trend to a bullish (up-) trend. This will be labeled with suffix (BUY) because it gives a Buy signal. Then I will discuss the same signal in the reverse market conditions- in an up-trend, around Top prices, to identify reversals to a downtrend - from bullish sentiment to bearish sentiment. This will have suffix of (SELL). (BUY) signals can be used to close/cover existing short positions and/or to initiate fresh long positions. Similarly, (SELL) signals should be used for closing existing long positions and/or to initiate fresh short positions. As per our Price theory, trend reversals take place either (i) during market hours when trading is taking place due to sudden emergence of powerful buying or selling, or (ii) outside market hours (when trading is not taking place or the Market is closed) when some powerful news or event takes place. We can call these reversals intra-day and inter-day trend reversals respectively.
Intra-day reversals take place due to the release of some economical, political or general market related news or event(s) during market hours when trading is going on. Sometimes Intra-day reversals take place when influential traders, investors and/or institutions start buying/selling the stock to take advantage of its currently attractive price. Intra-day trend reversals are the most powerful reversals and they catch most of the ordinary investors and traders by surprise. This total change in sentiment is reflected in prices but only a few market players are able to comprehend what is happening and are able to take advantage of such reversals on the very same day. To name a few signals that fall in this category and about whom we are going to learn are U-TURN, TURN AROUND, REVERSE and WEEKLY REVERSALS.
Inter-day reversals take place when markets are closed. They may be due to the same reasons that cause intra-day reversals but here the reasons/events are happening over night or when the market is closed. Unlike intra-day reversals, these reversals often take place due to some company specific news or announcement of earnings. In the USA and also in the most other countries, companies are prohibited from releasing material information during market hours. So most of such information is disseminated before or after the market hours. Then when the market opens and the stock starts trading in the morning, there is usually a sudden jump or a fall in prices. However a higher or lower Open price is not a sufficient condition to term a day as a trend reversal day. One needs to watch the entire day's trading to see if the real buying and selling confirmed the sentiment indicated by the Open price. Some of the Inter-day signals, like JUMP START and FREE FALL, are also powerful indicators of trend reversals.
Click here to learn our first trend reversal signal: U-TURN
Disclaimer: This trading system/signal, like any other system, may fail at times. Exercise caution when trading and decide suitability of any trade by taking into consideration market conditions, your financial situation, investment objectives and circumstances. Always keep a stop-loss when you are trading.
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