Trend Reversal Trading Strategies – Setup, Rules, Backtest, Performance Analysis
A trend reversal is a change in the direction of the price trend of an asset. This change in direction can be to the upside or downside. The trend reversal strategy is any analysis or trading technique a trader uses to identify the end of one trend and the beginning of another. Trend-reversal strategies can be used on any timeframe and can mean the difference between a big win, a break-even, or a loss, as being able to effectively spot a reversal is the fastest way to get into a potentially profitable trade.
In this post, we take a look at the trend reversal trading strategy, and we have also included a backtest.
Trend Reversal Trading Strategies
“The trend is your friend until the end when it bends.” — Ed Seykota. No matter the strength and duration, most trends would eventually come to an end, so it pays to know how to spot that when it happens. So, what is a trend reversal strategy?
Before you start reading, we list our articles that can be labeled trend reversal trading strategies:
Here you can find all our Trend reversal trading strategies.
What is a trend reversal?
A trend reversal is when the price direction of an asset has changed, and the change can be to the upside or downside. A trend reversal signals the end of one trend and the beginning of another.
Thus, a reversal following an uptrend would be to the downside, while a trend reversal following a downtrend would be to the upside. Reversals tend to be based on the general price direction rather than just one or two periods or bars on a chart.
Since price trends can occur on any timeframe, trend reversals can also occur on any timeframe. Different traders trade different timeframes, depending on their trading style, so anyone can make use of trend reversal strategies, regardless of the timeframe on which they trade.
While an intraday reversal on a five-minute chart doesn’t matter to a position trader who looks for a reversal on daily or weekly charts, it would mean so much to a scalper monitoring the 5-minute and 1-minute charts.
As you should already know, an uptrend is a series of higher swing highs and higher swing lows, so when it reverses into a downtrend, you should expect to see a series of lower swing highs and lower swing lows. Likewise, when a downtrend, which is a series of lower swing highs and lower swing lows, reverses into an uptrend, you expect the emergence of a series of higher swing highs and higher swing lows.
You can identify trends and reversals using this characteristic price action pattern of swing highs and lows. In doing so, you may want to use a trendline to mark the ascending or descending swings, as the case may be.
Since an uptrend makes higher swing lows, its lower limit can be delineated with a trendline drawn along those ascending swing lows. So, when the price drops below the trendline, that could signal the reversal of the uptrend to a downtrend.
The opposite is true in a downtrend where the price pattern has descending swing lows: a trendline drawn across the descending swing highs can mark the boundary of the downtrend such that when the price rises above the trendline, that could signal the reversal of the downtrend to an uptrend.
Some traders prefer the use of indicators, such as a moving average, oscillator, or channels (Donchian, Keltner, and Bollinger Bands) to identify the trend and its reversal.
For example, moving averages may aid in spotting both the trend and reversals. If the price is above a rising moving average, then the trend is up; so when the price drops below the moving average, that could signal a potential price reversal to the downside.
Similarly, the price trading below a descending moving average signals a downtrend, so when the price rises above the moving average, that could signal a potential price reversal to the upside.
Whether you are using price action or indicators, price reversals are not easy to identify as the early parts of the reversals are not different from pullbacks. There are often many false signals, and sometimes, a reversal can happen so quickly that you can’t spot them early enough to trade them or avoid taking a hit if it happens against your position.
What is the best trend reversal indicator?
If you are a price action trader, you may want to use, you may want to use a trendline to mark the direction of the trend. The tool also doubles as a dynamic support (uptrend) or resistance (downtrend) level where pullbacks are expected to reverse, such that the price closing beyond it would signal a trend reversal.
For someone who uses only indicators, there are many indicators you can use to spot a trend reversal, such as moving averages, the moving average convergence and divergence (MACD), Donchian and Keltner channels, Bollinger Bands, as well as oscillators like the relative strength index (RSI) and stochastic.
Each of these indicators has its merits and demerits, so it is difficult to choose the best indicator for trend reversals. Some indicators work on certain assets and not so well on others.
The moving average can be used in different ways to show the trend and when it has reversed. For example, the slope can tell you the trend direction, and when the slope changes direction, it could signal a change in trend. But this tends to lag the price by a lot when the period setting is large enough, say 200-day moving average. A combination of two moving averages can also be used, whereby a crossover trading system indicates a trend change — an upward cross of the smaller-period moving average (golden cross) indicates an emerging uptrend, while a downward cross of the smaller-period moving average (dead cross) indicates an emerging downtrend. However, that is often associated with many false signals.
Oscillators may signal a potential trend reversal early enough with their overbought/oversold signal or the divergence signal, but they usually give many false signals, which makes them unreliable for trend reversals. They are better suited for spotting pullback reversals within a trend — that is, it is better to use them to spot when a pullback has ended and reversed into a trend-continuation impulse swing.
The other indications mentioned above are derivatives of the moving average. The MACD is an advanced form of a moving average crossover signal. So, they are often associated with the lag that is inherent in most moving average indicators.
Trend reversal strategies and indicators
We have covered many more potential trend reversal trading strategies:
Here you can find all our Trend reversal trading strategies.
Are trading reversals profitable?
Yes, trend reversal trading can be a profitable way to trade the markets. But as with any other trading method, it does not work all the time, even when you use the most complicated reversal patterns, and it also depends on the market/asset you are trading.
Some reversal methods are based on price action — spotting a change in the characteristics of the price swings. In some cases, this has been used to create reversal chart patterns, such as the head and shoulders pattern, double top/bottom, and triple top/bottom.
Some traders, on the other hand, use indicators to spot a potential reversal. Depending on the indicator, the signal can be a change in the slope of the indicator, a breakout, an overbought/oversold signal, or a divergence. Whether you use price action or indicators to identify reversals, make sure you backtest the method to be sure it actually makes money in the market you want to trade. The good thing about indicator methods is that they are easier to code.
What are trend strategies?
They are strategies used by traders to trade in the direction of the trend. Trend trading strategies are based on the idea that the price of a security will continue to move in the same direction it is trending until it has been convincingly shown to have changed direction. Trend trading usually involves the use of technical indicators to identify the direction of market momentum.
Such strategies often use the breakout of price ranges, channels, support/resistance levels, or trendlines to identify the emergence of a new trend and then trade in that direction. An example of a trend strategy is the Donchian channel trend strategy, where a 20-day high is used to indicate a trade entry. There are also the Bollinger Channel breakout strategy and ATR channel breakout strategy. Some use price action pattern breakouts, such as the breakout from a rectangle pattern (aka range-bound market).
Many trend strategies use stop-loss and trailing-stop methods to lock in profits or avoid big losses if a trend reversal occurs.
What are the signs of a trend reversal?
A trend has a characteristic manner of price movements. In an uptrend, there is a series of higher swing highs and higher swing lows, while in a downtrend, there is a series of lower swing highs and lower swing lows. So, you can identify a trend reversal using a breakdown of the characteristic price action pattern of swing highs and lows that mark the trends.
When an uptrend reverses to a downtrend, that pattern of higher swing highs and higher swing lows breaks down, and you will see a lower swing high and lower swing low, which is characteristic of a downtrend. In the same way, when a downtrend reverses into an uptrend, that pattern of lower swing highs and lower swing lows that characterizes a downtrend breaks down, and you would see a combination of higher swing high and higher swing low.
The easiest way to spot this is using a trendline, which marks the ascending swing lows in an uptrend and the descending swing highs in a downtrend. So, when the price drops below the trendline in an uptrend, it could signal the reversal of the uptrend to a downtrend. Likewise, when the price closes above the trendline in a downtrend, it could signal the reversal of the downtrend to an uptrend.
Trend reversal pattern example
The characteristic pattern of any trend reversal is the breakdown of the series of price swings that formed the trend.
For example, an uptrend consists of a series of higher swing highs and higher swing lows. When the uptrend reverses, that pattern of higher highs and higher lows breaks down, giving way to a combination of a lower low and a lower high, as you can see in the chart below: Notice the yellow trendline, the lower swing high and lower swing low.
Traders have used These transitional price swings over the years to identify reversals. Over time, some unique transitional swing patterns have been classified as reversal chart patterns, with each named after the structure it resemble.
We have the head and shoulders pattern, the double top/bottom pattern, the triple top/bottom pattern, and the wedge pattern. In any of these patterns, you will see the price swings transitioning from the characteristics of one trend to another. See an example of the double top pattern below:
In the chart, you can notice that, by the virtue of having a double top, the price stopped making a significantly higher high. What followed was a break below the preceding swing low, which marked the neckline, to make a lower swing low — an indication of the transition to a downtrend. The next swing high was also a lower high, confirming that a downtrend has set in.
Trend-reversal indicator
There are many indicators that can be used to track trend reversals. Examples include moving averages, MACD, Donchian and Keltner channels, Bollinger Bands, and oscillators like the RSI and stochastic.
A change in the slope of the moving average can indicate a trend reversal. Another method is to use two moving averages of different periods, whereby a crossover indicates a trend change — when the smaller-period moving average crosses above (golden cross) the longer one, it indicates an emerging uptrend. A downward cross of the smaller-period moving average (dead cross) indicates an emerging downtrend.
The Donchian and Keltner channels and the Bollinger Bands use breakout methods to signal a trend reversal. A breakout above the channel indicates an emerging uptrend, while a breakout below the channel indicates a potential downtrend. The MACD and the oscillators may signal trend reversal with their overbought/oversold signal or the divergence signal.
How do you find trend reversals?
You spot a trend reversal by watching for the breakdown of the series of price swings that characterize the trend. For example, an uptrend consists of a series of higher swing highs and higher swing lows. So, if that pattern of higher highs and higher lows breaks down, giving way to a combination of a lower low and a lower high, you can assume that the uptrend is reversing to a downtrend.
Similarly, if a downtrend, which is characterized by a series of lower swing lows and lower swing highs, suddenly develops a combination of a higher swing high and higher swing low, you can assume that the downtrend is reversing to an uptrend.
One easy way to spot a trend reversal is by the use of a trendline. When the price drops below the trendline in an uptrend, it could signal the reversal of the uptrend to a downtrend. Likewise, when the price closes above the trendline in a downtrend, it could signal the reversal of the downtrend to an uptrend
How do you distinguish between trend reversal and retracement?
It is not easy to distinguish between a retracement and trend reversal, especially at the initial stages. If reversals were easy to spot, and to differentiate from retracements, trading would be easy, but it is not. The early part of a trend reversal is just like a retracement, and if you trade it as such, you might get stopped out if it turns out to be a trend reversal. This is one of the headaches in trading, so you only play the odds and manage risks.
However, for an experienced trader, there are some signs that can tell. For example, if the price makes a double bottom and starts to rally, the likelihood f that rally turning out into a trend reversal may be more than that of it being a retracement. The reason is that the double bottom shows that the price could not make a lower low expected in a downtrend.
Another sign is a trendline breakout. Retracements usually respect the main trendline, so whenever that trendline is breached, what is going on is no longer a mere retracement — the trend may be about to change direction. You only confirm when the price swing pattern that characterizes the opposite trend appears.
Lastly, you can use the Fibonacci retracement tool to distinguish between a reversal and a retracement. When a retracement extends beyond the 100% Fibonacci retracement level, it is no longer a retracement — a potential reversal may be in the cards. You confirm this if, in the next swing, the price fails to reach the initial level from where it started retracing.
How do you use RSI for trend reversal?
A long-period RSI may be useful in identifying a trend reversal. Its oversold/overbought signal and classical divergence signal may be an early indication of a trend reversal.
- What does overbought stock mean (rules and backtest)
- What does oversold stock mean (rules and backtest)
However, the RSI must be seen to rise above the 30 level (in the case of a bullish reversal from a downtrend) or fall below the 70 level (in the case of a bearish reversal from an uptrend).
How do you identify a pullback and reversal?
A pullback would usually respect the main trendline, while a reversal would not. Whenever a trendline is breached, it is more likely to be a reversal than a pullback unless it is a false breakout.
- Pullback Trading Strategy (S&P 500, Setup, Rules, Backtest, Performance)
Another method is to use the Fibonacci retracement tool. When a retracement extends beyond the 100% Fibonacci retracement level, it is no longer a pullback. It could be the first swing of a potential reversal.
Trend reversal trading strategy backtest
Let’s look at some potential trend reversal trading strategies.
We start with an engulfing candlestick pattern reversal. We are looking for an exhaustion setup and we make the following trading rules:
Trading Rules
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First, we backtest the trading strategy on NASDAQ 100 and the ETF that tracks the index: QQQ.
It’s 285 trades, and the average gain per trade is a solid 0.86% which leaves a considerable margin of safety for commissions and slippage. Max drawdown is 22%, tiny compared to 83% for buy and hold. CAGR is 9.9%, dividends reinvested, which is more or less the same as buy and hold despite being invested only 19% of the time.
If we use the same trading rules on bonds (TLT) it also works pretty well:
The average gain is lower than for QQQ, 0.4%, which is expected because of much lower volatility for bonds compared to stocks. There are 221 trades, and the max drawdown is only 12% (and short-lived).
The main benefit of trading bonds is diversification, which we consider the only Holy Grail trading strategy.
If we employ the same strategy on both instruments and trade it as a portfolio allocating 100% of the equity for each trade, the strategy performs like this:
For example, if we get a trade signal in QQQ, we ignore any buy signals in TLT until the QQQ is sold and we are in cash.
The backtest above is from 1999, but TLT only started trading in 2002, and thus both assets are traded only from 2002.
The CAGR increases to almost 13% while we are still only invested 28% of the time. However, max drawdown is reduced to 18% (compared to only trading QQQ), and the longest drawdown is less than a year. We believe these are pretty solid performance metrics.
FAQ:
How can I identify a trend reversal?
Trend reversals can be identified by observing a breakdown of the characteristic price action pattern, such as a series of higher highs and higher lows in an uptrend or lower highs and lower lows in a downtrend. Trendlines and indicators like moving averages, MACD, and RSI can aid in spotting reversals.
What are some common trend reversal chart patterns?
A trend reversal in trading refers to a change in the direction of the price trend of an asset. It can be a shift from an uptrend to a downtrend or vice versa. Common trend reversal chart patterns include head and shoulders, double top/bottom, triple top/bottom, and wedge patterns. These patterns signal a transition from one trend to another.
How do I distinguish between a trend reversal and a retracement?
Distinguishing between a trend reversal and a retracement can be challenging. Signs of a potential reversal include a breach of trendlines, failure to make a lower low in a double bottom, and extended retracement beyond the 100% Fibonacci retracement level.