Trend Trading vs. Reversal Trading

05/17/2011 10:00 am EST

Focus: STRATEGIES

Jackie Ann Patterson

Author, Truth About ETF Rotation

BackTesting Report editor Jackie Ann Patterson discusses these two different approaches and notes that to be successful in either, traders can't afford to lose track of risk management.

Well traders know and have probably heard the phrase, "The trend is your friend," but if that trend reverses, it may not be.

We're going to talk about trading trends versus trading reversals today with Jackie Ann Patterson. So Jackie, first of all, what is the difference between trading on a trend and then trading a reversal?

Okay, the trend basically is looking at the price activity and seeing that it's been going more or less in the same direction over a period of time, and that period of time can be variable. I mean, for a short-term trader, that might be five minutes, ten minutes, or fifteen minutes. 

For a long-term trader, that might be five years. It just depends. Of course, there's everything in between. So the idea behind trend trading is to assess what the trend is and to go with it. 

The other idea with trading is to look for reversals; reversals and reversions to the mean. So that notion is that when the price has moved a certain degree in one direction, sooner or later it's going to turn in the other.

That, I think, is the basis of the mean reversion, which might be a short-term market reversal. There's also the notion of an all-out market reversal. There's different indicators and different ways to assess whether that might be about to occur.

So recently we've seen a great market run-up here, and traders seem to want to find that top. They're determined that it's going to reverse here and yet it always continues to go further. Any suggestions about ways we can really spot if a top is coming or things that have worked for you?

Well, yes. So I've certainly been there and I've certainly been watching the market run on and on and anticipating a turn. I think there's a couple of things we can do. 

One is that there are some indicators that can help us. We can look for divergences in different areas, whether it's an indicator divergence like an MACD divergence, for example; might be a market internals divergence where we're seeing a difference in the count of the number of divergences across the whole stock market; might be a difference in the new highs and new lows. 

So being alert to things that are not quite consistent with the ongoing trend. That said, those things can happen and the trend still not reverse. We've seen some pretty strong trends in this market. 

I think the thing to do there is to always manage your risk. You know, you always have to be open to the possibility that what you think and what you're so certain is going to happen, it might not happen. 

It's important to have the risk small enough to be able to come back again and again and again.

If, for example, you're trying to trade counter to the prevailing trend, or you think you're going with the trend and it's reversing-either one-you need to be able to sustain a few losses until the market moves in your direction.

Then it's important to capitalize on those moves.

Basically giving yourself time to be right, it sounds like.

Yes, that's it exactly.

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