Trend Trading vs Reversal Trading

Success as a trader largely relies on the strategy that you follow. Trend trading and reversal trading are two well-recognized methods that many traders take advantage of in their approach to the wide range of trading opportunities.

Trend trading seeks to analyze the direction of the price of an asset or market and take advantage of it. This overall direction is called a trend, whether upward or downward.

When the trend is upward, trend traders may take a long position and ride the upward trend in price. When the trend is downward, trend traders will generally take a short position, selling before the price falls too greatly.

A trend trader may even buy or sell while the trend is still operating in their favor if they feel that the trend may change direction.

Reversal trading, by contrast, analyses and seeks to take advantage of changes in the direction of a trend. A change in the trending price direction is called a reversal.

Reversal trading carries a higher level of risk, however, as it relies on predicting when a true reversal will occur, as opposed to a pullback.

A pullback is a change in the direction of the price – for instance, down in an upward trend – that does not affect the overall trend. You may also hear the term ‘retracement’. This is synonymous with a pullback.

A reversal trader will generally wait to identify a reversal before they buy or sell, meaning that their trade happens after the change in direction has occurred.

With the first of the above strategies seeking to follow the trend and the second acting against the trend, it might seem that using one would exclude the use of the other. However, the methods of trend trading and reversal trading can be complementary when seeking success as a trader.

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Benefits of Trend Trading

While the two strategies can work well together, it can be simpler to use just one. Trend trading alone does have certain benefits.

Stability

Trend trading is generally seen as a safer approach to trading because it follows the direction of the market.

Once a trend has been identified, the trader can usually predict how that asset or market will perform in the near future. There may be fluctuations in price, but the overall trend will continue in the same direction.

The challenge is to analyze whether a trend is likely to persist, using methods like trendlines, moving averages and the relative strength index (RSI).

Lower Risk

Trend traders know what to do once an asset or market begins a recognized downward trend – sell. The level of risk is lowered because they follow reasonably predictable market trends.

Having ridden an upward trend, possibly from its beginning, the trend trader can safely sell at the beginning of a downward trend and maximize their profits.

More Common/Higher Probability

Trends tend to be long-lasting whereas reversals, by comparison, are much rarer. This means that a trend trader has more opportunities to take advantage of than a reversal trader.

Add to this the fact that trading with the trend provides a higher probability of success, and trend trading begins to look like the best option.

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Benefits of Reversal Trading

Trend trading seems like a better option at first glance. But reversal trading also has many benefits – larger profits for one.

Get in at the Start

The focus of reversal trading is to carefully monitor the markets for indications that the price of an asset or market is likely to change direction. This knowledge provides you with an opportunity to jump on trends from the beginning.

If the trend is upward, you will be able to buy low and then ride the rising price until the trend changes. If the trend is downward, you can sell your stock, forex, cryptocurrency (for example, Bitcoin) or asset before the price drops any further.

The ability to react to a trend at its beginning will increase your likelihood of making a higher profit from your trading.

Higher Risk to Reward Ratio – Better Profits

The risk-to-reward ratio compares how much money the trader is putting at risk when making a trade with how much return (reward) that trade may earn. For example, if you risk $500 for a possible $3,000 return, that is a 1:6 ratio.

Generally, a risk-to-reward ratio minimum is accepted as 1:3. A ratio that is higher than this offers higher rewards but also a higher risk.

In reversal trading, the risk-to-reward ratio is higher than if you follow the trend of your asset or market. This means that the return on your trades is likely to be higher, thus cushioning any losses you may make.

More risk, but greater rewards make reversal trading an exciting way to make money.

Good Addition to Trend Trading

As mentioned at the beginning of this article, it is not necessarily a case of being a trend trader or a reversal trader. The two strategies can, in fact, complement each other.

Trend trading is reliant on following a trend until it no longer serves your purposes. In other words, once the trend heads downwards, the trend trader sells.

The methods used to predict a reversal, the change in direction of a trend, can be a useful aid to a trend trader’s ability to predict market trends.

Limitations of Reversal Trading

Reversal trading’s limitations are based on the nature of reversals themselves. Initially, it can be difficult to tell whether an apparent change in direction of the price of a market is a true reversal or simply a pullback.

Once it becomes clear that a reversal has occurred, the price of the market may already have altered drastically. In the case of a reversal into a downward trend, the price may have fallen a sizeable amount. In a reversal into an upward trend, the cost to buy may have risen to a level that makes it a less profitable prospect.

The methods used to predict a reversal may also work against the trader because one method may indicate the likelihood of a reversal whereas another will not. Reversal trading relies on successfully using several methods and interpreting their results as a whole.

How to Identify Reversals

Whether you use reversal trading as a lone strategy or to inform trend trading, you must learn how to identify when a reversal will happen.

Many methods can be used together to build a more detailed answer to the question, ‘Will this market trend reverse soon?’

Before looking at each of these methods, it might be useful to examine how trendlines enable a reversal trader to identify the direction of a trend and its developing upper and lower limits.

In the simplified diagram above, the black line shows the price of an asset, or market overall, increasing and decreasing. As you can see, it is not a steady rise or fall but a progression of price changes.

The trend is identified by finding the highest and lowest points of the price’s oscillation and examining their direction. These are indicated by the two orange lines.

If both of these are increasing in price over a decent period, the trend is upward. If both, instead, are decreasing, the trend is downward. In an upward trend, the terms used are high highs and high lows. In a downward trend, they are called low highs and low lows.

To predict a reversal, the behavior and extent of the oscillations in price in relation to the accompanying trend can be analyzed in several ways:

Bounce Failure in Trend Line

A ‘bounce’ is the price’s journey up from the bottom trendline. In a downward trend, this is called a ‘dead cat bounce’. A bounce’s real value as an analytical indicator is in an upward trend.

When the price of a market or asset creates a new high low, it will touch the bottom trendline. If that action then rises to create a new high high, this is called a bounce.

A bounce does not have to go straight from a high low to a high high, but it should continue in that general direction. There are two bounces in the above diagram – one at the beginning and one around three-quarters along.

Should the price rise from a high low but not create a new high high before falling again, this is a bounce failure.

Pullback or Retracement

A pullback or retracement is a change in a market price’s direction that is opposite to the overall trend. Alone, a pullback will not change the direction of the trend but the pattern in the size of successive pullbacks may indicate that a reversal is likely to happen.

For instance, in an upward trend where the size of pullbacks grows larger with each occurrence, the momentum of the upward direction appears to be slowing and the possibility of a reversal, a change to a downward trend, is increasingly likely.

Trend Waves

A trend wave is an extension from a high low to a high high in an uptrend or low high to low low in a downtrend.

Where the size of those trend waves is steadily decreasing, this is an indicator that a reversal is likely to happen.

Trend Structure Change

In an upward trend, there are high highs and high lows. In a downward trend, there are low highs and low lows. These form the structure of your trend. But that structure may unexpectedly change.

For instance, in a downward trend, the price of your market is reliably hitting those low highs and low lows. But it may hit a new high low.

Equally, an upward trend could suddenly result in a low low.

Either of these would indicate that a trend reversal is on the way.

Cross-Check with Current Events

This is a different kind of tool but one that can be useful in predicting the likelihood of changes in the financial markets.

Take the example of the Covid-19 pandemic:

• General spending slowed as consumers worried about the security of their jobs and many found themselves out of work.
• Combined with consumers’ financial worry, lockdown and social distancing meant less leisure spending, whether goods, services or locations to visit.
• Tech stocks benefitted from the move to working from home and the use of online connection and entertainment, such as the uptake of video conferencing for work meetings and family catchups.
• The commodities market became increasingly volatile, for instance, agriculture experienced initial losses but later recovered.
• Taking advantage of plunging prices, a whole host of first-time investors came on-board, bringing new money and eyes to the markets.
• Even though there was a dramatically increased need for hospitals, many health-related stocks dropped in price as hospitals and clinics braced themselves for the impact of the pandemic and spent less as a result.

Knowing how specific brands and industries are performing in the real world can provide you with an indicator of how the related markets, be those shares, commodities or currency, will behave.

Final Thoughts

As a trader, having a keen eye on how the markets are performing is paramount.

If trend trading provides a relative safety net in its adherence to market momentum, reversal trading equips the trader with a way to predict changes in trend direction.

While either can be used as sole strategies in their own right, trend trading and reversal trading are most useful when considered together.

WikiJob does not provide tax, investment or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.