How to Spot the Signs of a Trend Reversal
12/06/2010 10:40 am EST
The recent 30-minute intraday chart of crude oil (futures – CL) serves as a great example of how a certain type of price reversal forms, along with showing specific components that go into the short-term trend reversal process.
Let’s take a moment to learn from this example and see the applicable lessons in this situation:
I’ll move quickly, so be sure to follow along. These components (divergences, kick-offs, and breakouts) are topics on which I’ve presented entire Webinars or speaking presentations, and this example is a bit of a quick “all-in-one” summary of these topics.
Let’s take it bit by bit in terms of the sequential process of a short-term trend reversal.
1. Multi-Swing Momentum Divergences
Under the principle “Momentum precedes price,” positive momentum divergences (particularly those of the multi-swing variety) often precede positive price reversals.
I’m using the 3/10 MACD oscillator as my preferred momentum indicator (change your MACD to [3, 10, 16], or [3, 10, 0] to replicate).
So we have a new oscillator low just before November 14, and from there, though price traded lower, the oscillator formed higher lows, particularly those from November 17 forward to the absolute price low on November 23.
Ok, so that’s condition one complete. Multi-swing positive momentum divergences often precede reversals. Check.
2. Kick-off Momentum Bursts
I’ve also referred to these as “Wyckoff signs of strength,” wherein a momentum oscillator or market internal (in stocks) makes a new chart high when price is clearly not making a new chart high (on a relative/short-term basis).
I call these “kick-offs” because they can often begin a new trend ahead of an actual price reversal or official breakout yet to come.
Richard Wyckoff described these (similarly) in his “Life Cycle of a Stock Move” model (often occurring after a distinct accumulation/consolidation phase, as in the case of a stock).
Like a football moving quickly down the field after a punt or kickoff, odds are that price will similarly continue moving in the same direction as the kick-off signal.
This is also based on the momentum principle, wherein new momentum highs often precede new price highs yet to come.
When a kick-off clearly forms after a multi-swing divergence, it’s certainly time to cover short positions, and for aggressive traders, it’s time to consider getting long on the immediate pullback or on a breakout signal.
For reference, I’m pointing to two kick-off signals.
The initial one on November 23 ahead of the official price breakout, and then of course the obvious new momentum high and second kick-off the next day on November 24.
3. Official Breakout
If you’re a new trader and haven’t heard of the multi-swing divergence or kick-off concepts, then you’ve almost certainly heard of a price breakout.
No need to get fancy here—price clearly broke out above the recent short-term range at the $82.00 level and above a declining trend line from the prior two swing highs as drawn.
Breakouts are good places for aggressive traders (willing to tolerate risk) to get long to play for a big target in the event that price does indeed reverse its trend and the breakout is real.
Traders need to enter breakouts as early as possible and hold on for as long as possible, though that’s a much more complicated task than it seems, and it’s more than a single blog post can address.
I’ll be discussing Execution Tactics at the New York Trader’s Expo in February 2011 (look into attending now and registering early!).
Anyway, with these three sequential components complete on the intraday basis, what was the result (so far?):
A rally from the $82 breakout to the $86 level a few days later, and potentially beyond that if the trend continues (as of this writing on December 1).
When you’re looking to confirm a reversal, or see if a breakout is more likely to be real than a trap, look to see if positive multi-swing divergences preceded it (perhaps on a lower time frame) and if so, look for an initial “kick-off” sign of strength signal after that, and while it won’t always result in magic money, it will give you a structure and plan to follow for future trades.