Trading Price Action Reversals

Technical Analysis of Price Charts Bar by Bar for the Serious Trader

Al Brooks

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9781118066614
• eBook ISBN: 9781118172308
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

A detailed guide to profiting from trend reversals using the technical analysis of price action

The key to being a successful trader is finding a system that works and sticking with it. Author Al Brooks has done just that. By simplifying his trading system and trading only 5-minute price charts he's found a way to capture profits regardless of market direction or economic climate. His first book, Reading Price Charts Bar by Bar, offered an informative examination of his system, but it didn't allow him to get into the real nuts and bolts of the approach. Now, with this new series of books, Brooks takes you step by step through the entire process.

By breaking down his trading system into its simplest pieces: institutional piggybacking or trend trading, trading ranges, and transitions or reversals (the focus of this book), this three book series offers access to Brooks' successful methodology. Trading Price Action Reversals reveals the various types of reversals found in today's markets and then takes the time to discuss the specific characteristics of these reversals, so that you can use them in your everyday trading endeavors. While price action analysis works on all time frames, there are different techniques that you can use in trading intraday, daily, weekly and monthly charts. This, among many other issues, is also addressed throughout these pages.

• Offers insights on how to handle volatility and sharp reversals
• Covers the concept of using options when trading certain charts
• Examines how to deal with the emotions that come along with trading
• Other books in the series include Trading Price Action Trends and Trading Price Action Trading Ranges

If you're looking to make the most of your time in today's markets the trading insights found in Trading Price Action Reversals will help you achieve this goal.

PART I

Trend Reversals: A Trend Becoming an Opposite Trend

One of the most important skills that a trader can acquire is the ability to reliably determine when a breakout will succeed or reverse. Remember, every trend bar is a breakout, and there are buyers and sellers at the top and bottom of every bull and bear trend bar, no matter how strong the bar appears. A breakout of anything is the same. There are traders placing trades based on the belief that the breakout will succeed, and other traders placing trades in the opposite direction, betting it will fail and the market will reverse. A reversal after a single bar on the 15 minute chart is probably a reversal that took place over many bars on the 1 minute chart, and a reversal that took place over 10 to 20 bars can be a one-bar reversal on a 120 minute chart. The process is the same on all time frames, whether it takes place after a single bar or many bars. If traders develop the skill to know which direction the market will likely go after a breakout attempt develops, they have an edge and will place their trades in that direction.

Reversal setups are common because every trend bar is a breakout and is soon followed by an attempt to make the breakout fail and reverse, as discussed in Chapter 5 of book 2. If the breakout looks stronger than the reversal attempt, the reversal attempt will usually not succeed, and the attempt to reverse will become the start of a flag in the new trend. For example, if there is a bull breakout of a trading range and the bull spike is made of two large bull trend bars with small tails, and the next bar is a bear doji bar, that bear bar is an attempt to have the breakout fail and reverse back down into a bear trend. Since the breakout is much stronger than the reversal attempt, it is more likely that there are more buyers than sellers below the bear bar, and that the entry bar for the short will become a breakout pullback buy signal bar. In other words, instead of the reversal succeeding, it is more likely that it will become the start of a bull flag and be followed by another leg up. If the reversal setup looks much stronger than the breakout, it is more likely that the breakout will fail and that the market will reverse. Chapter 2 in book 2 discusses how to gauge the strength of a breakout. In short, the more signs of strength that are present, the more likely that the breakout will succeed and that the reversal attempt will fail and lead to a breakout pullback setup.

Institutional trading is done by discretionary traders and computers, and computer program trading has become increasingly important. Institutions base their trading on fundamental or technical information, or a combination of both, and both types of trading are done by traders and by computers. In general, most of the discretionary traders base their decisions primarily on fundamental information, and most of the computer trades are based on technical data. Since the majority of the volume is now traded by HFT firms, and most of the trades are based on price action and other technical data, most of the program trading is technically based. In the late twentieth century, a single institution running a large program could move the market, and the program would create a micro channel, which traders saw as a sign that a program was running. Now, most days have a dozen or so micro channels in the Emini, and many have over 100,000 contracts traded. With the Emini currently around 1200, that corresponds to $6 billion, and is larger than a single institution would trade for a single small trade. This means that a single institution cannot move the market very far or for very long, and that all movement on the chart is caused by many institutions trading in the same direction at the same time. Also, HFT computers analyze every tick and are constantly placing trades all day long. When they detect a program, many will scalp in the direction of the program, and they will often account for most of the volume while the micro channel (program) is progressing.

The institutions that are trading largely on technical information cannot move the market in one direction forever because at some point the market will appear as offering value to the institutions trading on fundamentals. If the technical institutions run the price up too high, fundamental institutions and other technical institutions will see the market as being at a great price to sell out of longs and to initiate shorts, and they will overwhelm the bullish technical trading and drive the market down. When the technical trading creates a bear trend, the market at some point will be clearly cheap in the eyes of fundamental and other technical institutions. The buyers will come in and overwhelm the technical institutions responsible for the sell-off and reverse the market up. Trend reversals on all time frames always happen at support and resistance levels, because technical traders and programs look for them as areas where they should stop pressing their bets and begin to take profits, and many will also begin to trade in the opposite direction. Since they are all based on mathematics, computer algorithms, which generate 70 percent of all trading volume and 80 percent of institutional volume, know where they are. Also, institutional fundamental traders pay attention to obvious technical factors. They see major support and resistance on the chart as areas of value and will enter trades in the opposite direction when the market gets there. The programs that trade on value will usually find it around the same areas, because there is almost always significant value by any measure around major support and resistance. Most of the programs make decisions based on price, and there are no secrets. When there is an important price, they all see it, no matter what logic they use. The fundamental traders (people and machines) wait for value and commit heavily when they detect it. They want to buy when they think that the market is cheap and sell when they believe it is expensive. For example, if the market is falling, but it’s getting to a price level where the institutions feel like it is getting cheap, they will appear out of nowhere and buy aggressively. This is seen most dramatically and often during opening reversals (the reversals can be up or down and are discussed in the section on trading the open later in this book). The bears will buy back their shorts to take profits and the bulls will buy to establish new longs. No one is good at knowing when the market has gone far enough, but most experienced traders and programs are usually fairly confident in their ability to know when it has gone too far.

Because the institutions are waiting to buy until the market has become clearly oversold, there is an absence of buyers in the area above a possible bottom, and the market is able to accelerate down to the area where they are confident that it is cheap. Some institutions rely on programs to determine when to buy and others are discretionary. Once enough of them buy, the market will usually turn up for at least a couple of legs and about 10 or more bars on whatever time frame chart where this is happening. While it is falling, institutions continue to short all the way down until they determine that it has reached a likely target and it is unlikely to fall any further, at which point they take profits. The more oversold the market becomes, the more of the selling volume is technically based, because fundamental traders and programs will not continue to short when they think that the market is cheap and should soon be bought. The relative absence of buyers as the market gets close to a major support level often leads to an acceleration of the selling into the support, usually resulting in a sell vacuum that sucks the market below the support in a climactic sell-off, at which point the market reverses up sharply. Most support levels will not stop a bear trend (and most resistance levels will not stop a bull trend), but when the market finally reverses up, it will be at an obvious major support level, like a long-term trend line. The bottom of the sell-off and the reversal up is usually on very heavy volume. As the market is falling, it has many rallies up to resistance levels and sell-offs down to support levels along the way, and each reversal takes place when enough institutions determine that it has gone too far and is offering value for a trade in the opposite direction. When enough institutions act around the same level, a major reversal takes place.

There are fundamental and technical ways to determine support. For example, it can be estimated with calculations, like what the S&P 500 price earnings multiple should theoretically be, but these calculations are never sufficiently precise for enough institutions to agree. However, traditional areas of support and resistance are easier to see and therefore more likely to be noticed by many institutions, and they more clearly define where the market should reverse. In both the crashes of 1987 and 2008–2009, the market collapsed down to slightly below the monthly trend line and then reversed up, creating a major bottom. The market will continue up, with many tests down, until it has gone too far, which is always at a significant resistance level. Only then can the institutions be confident that there is clear value in selling out of longs and selling into shorts. The process then reverses down.

The fundamentals (the value in buying or selling) determine the overall direction, but the technicals determine the actual turning points. The market is always probing for value, which is an excess, and is always at support and resistance levels. Reports and news items at any time can alter the fundamentals (the perception of value) enough to make the market trend up or down for minutes to several days. Major reversals lasting for months are based on fundamentals and begin and end at support and resistance levels. This is true of every market and every time frame.

It is important to realize that the news will report the fundamentals as still bullish after the market has begun to turn down from a major top, and still bearish after it has turned up from a major bottom. Just because the news still sees the market as bullish or bearish does not mean that the institutions still do. Trade the charts and not the news. Price is truth and the market always leads the news. In fact, the news is always the most bullish at market tops and most bearish at market bottoms. The reporters get caught up in the euphoria or despair and search for pundits who will explain why the trend is so strong and will continue much longer. They will ignore the smartest traders, and probably do not even know who they are. Those traders are interested in making money, not news, and will not seek out the reporters. When a reporter takes a cab to work and the driver tells him that he just sold all of his stocks and mortgaged his house so that he could buy gold, the reporter gets excited and can’t wait to find a bullish pundit to put on the air to confirm the reporter’s profound insight in the gold bull market. “Just think, the market is so strong that even my cabbie is buying gold! Everyone will therefore sell all of their other assets and buy more, and the market will have to race higher for many more months!” To me, when even the weakest traders finally enter the market, there is no one left to buy. The market needs a greater fool who is willing to buy higher so that you can sell out with a profit. When there is no one left, the market can only go one way, and it is the opposite of what the news is telling you. It is difficult to resist the endless parade of persuasive professorial pundits on television who are giving erudite arguments about how gold cannot go down and in fact will double again over the next year. However, you have to realize that they are there for their own self-aggrandizement and for entertainment. The network needs the entertainment to attract viewers and advertising dollars. If you want to know what the institutions are really doing, just look at the charts. The institutions are too big to hide and if you understand how to read charts, you will see what they are doing and where the market is heading, and it is usually unrelated to anything that you see on television.

A successful trend reversal is a change from a bull market to a bear market or from a bear market to a bull market, and the single most important thing to remember is that most trend reversal attempts fail. A market has inertia, which means that it has a strong propensity to continue what it has been doing and a strong resistance to change. The result is that there is really no such thing as a trend reversal pattern. When there is a trend, all patterns are continuation patterns, but occasionally one will fail. Most technicians will label that failure as a reversal pattern, but since most of the time it fails as a reversal and the trend continues, it is really more accurately thought of as just a continuation pattern. A trend is like a huge ship that takes a lot of force applied over time to change its direction. There usually has to be some increase in two-sided trading before traders in the other direction can take control, and that two-sided trading is a trading range. Because of this, most reversal patterns are trading ranges, but you should expect the breakout from the trading range to be in the direction of the trend because that is what happens in about 80 percent of cases. Sometimes the breakout will be in the opposite direction or the with-trend breakout will quickly fail and then reverse. When those events happen, most traders will label the trading range as a reversal pattern, like a double top, a head and shoulders, or a final flag. All of the reversal patterns listed in Part I can lead to a trend in the opposite direction, but they can also simply lead to a trading range, which is more likely to be followed by a trend resumption. In this case, the reversal pattern is just a bull flag in a bull trend or a bear flag in a bear trend.

When a trend reverses, the reversal can be sharp and immediate and have a lot of conviction early on, or it can happen slowly over the course of a dozen or more bars. When it happens slowly, the market usually appears to be forming just another flag, but the pullback continues to grow until at some point the with-trend traders give up and there is a breakout in the countertrend direction. For example, assume that there is a bear trend that is beginning to pull back and it forms a low 1 setup, but the market immediately turns up after the signal triggers. It then triggers a low 2 entry and that, too, fails within a bar or so. At this point, assume that either the market breaks out of the top of the bear flag or it has one more push up, triggering a wedge bear flag, the entry fails, and then the market has a breakout to the upside. A reversal at some point makes the majority of traders believe that the always-in position has reversed, and this almost always requires some kind of breakout. This is discussed in detail in Chapter 15, but it means that if you had to be in the market at all times, either long or short, the always-in position is whatever your current position is. The breakout characteristics are the same as with any breakout, and were discussed in the chapter on breakouts in Part I of book 2. At this point, there is a new trend, and traders reverse their mind-set. When a bull trend reverses to a bear trend, they stop buying above bars on stops and buying below bars on limit orders, and begin selling above bars on limit orders and selling below bars on stops. When a bear trend reverses to a bull trend, they stop selling below bars on stops and selling above bars on limit orders, and begin buying above bars on stops and buying below bars on limit orders. See Part III in the first book for more on trend behavior.

Every trend is contained within a channel, which is bordered by a trend line and a trend channel line, even though the channel may not be readil...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Dedication
• Acknowledgments
• List of Terms Used in This Book
• Introduction
• Part I: Trend Reversals: A Trend Becoming an Opposite Trend
• Part II: Day Trading
• Part III: The First Hour (The Opening Range)
• Part IV: Putting It All Together
• About the Author
• About the Website
• Index