Strategy Lesson: The Trend Reversal

05/09/2012 3:45 pm EST

Focus: STRATEGIES

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

The trend reversal strategy works in markets that aren’t in a firm uptrend and allows traders to identify early market leaders without having to call a bottom, explains Deron Wagner.

We’re talking about trading strategies with Deron Wagner and one of those strategies is the trend reversal. So Deron, how does the trend reversal strategy work?

The trend reversal play is one of our only set-ups used when the market is not in an uptrend. When the market is in an uptrend, we find our best, most profitable plays are typically relative strength breakouts or the pullback play.

See also: The Pullback Play Explained in Detail

The trend reversal play is used when the stock market has been in a protracted downtrend, say, for at least six months, and starts to show signs of a bottom. Our trend reversal play enables us to find the stocks that are likely to show early leadership and lead the way up when the market reverses higher.

Alright, talk about some of the parameters for when you get into this trade and when you get out.

One of the most important things is we don’t try to find a bottom. Don’t try to catch a falling knife. We wait for a lot of confirmation that a bottom has been put in place first, and we try to catch the meat of the move out of the middle.

So that’s the most important thing to understand. Now, in order to do that, there are a couple of things we look for. One is the 20-period moving average to cross up above the 50-day moving average, which is an indicator of a trend reversal.

And then we look for the 200-day moving average to be sloping higher, so we want the 20-, the 50-, and the 200-day all to be sloping higher, and we also want a higher low to be formed, or the start of a trend reversal.

So typically from the lows, that’s going to be at least two to three months off the lows, so it’s not like we’re trying to catch the bottom.

And how do you set profit targets and a stop loss on something like this?

Typically, we don’t set a profit target on this because we don’t know how far they’re going to go. We just use a trailing stop to move our profit target up as the train continues higher.

And, as with our other types of strategies, we keep it very simple, typically just using the 20-period exponential moving average and prior swing lows as stops.

Are there any stocks or ETFs that are looking good for this particular pattern now?

Right now, because the market had been trending higher for such a long period of time, we’re actually not actively looking for this type of trade, because anything that would just be reversing off of the lows now would have relative weakness to the broad market. We don’t want to be buying something with relative weakness.

We buy strong stocks and ETFs because, typically, the strong ones are the ones that move the highest. So this is not something that we’re using right now, but it’s good to know because we used it last year a lot when the market was trying to reverse off of the lows.

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