Example of How to Trade a Reversal
When traders enter a reversal trade, they are expecting the pullback from the trend to be large enough for a swing trade, or even a trend in the opposite direction. The entry, protective stops, and profit taking are then the same as for any other swing or trend trade, and were discussed in the first two books. Since traders are expecting a large move, the probability of success is often 50 percent or less. In general, when risk is held constant, a larger potential reward usually means a smaller probability of success. This is because the edge in trading is always small, and if there was a high probability of success, traders would neutralize it quickly and it would disappear within a few bars, resulting in only a small profit. However, since a trend reversal trade may have a reward that is several times larger than the risk, it can have a profitable trader’s equation.
Trading a reversal is much more difficult than it appears when a trader looks at a chart at the end of the day. Once there has been a strong break of the trend line and then a reversal on the test of the trend’s extreme, a trader needs a strong signal bar. However, it usually comes in a very emotional market at a time when beginning traders are still thinking that the old trend is in effect. They also probably lost on several earlier countertrend trades in the day and don’t want to lose any more money. Their denial causes them to miss the early entry. They then wait to ...