Successful hedge fund managers, such as Bruce Kovner, Ed Seykota and John Henry have been stalwarts of trend trading for years. This approach has been one of the most reliable trading methods devised for those seeking outsized returns. It has a proven history of producing large profits in everything from stock indexes to orange juice. It also was, perhaps most famously, the method used by a relatively well-known group of average people who Richard Dennis turned into profitable traders, known as the "Turtle Traders." Richard Dennis was a famously wealthy trend-trader himself.
But, at some point, all good things must end, including a trend.
When this occurs, a price reversal happens, and if you are unable to make the distinction between a price pullback and a price reversal, it can cost you dearly.
Price reversals can be brutal and sudden because when an existing mature trend is in place, it can catch complacent traders off guard, as if they are hit by a sucker punch.
The reason is any trend, no matter how strong or how long it has been in place, can outrun its underlying fundamentals or evolving technical criteria. Like a rubber band that has been stretched to its limit, at some point it will snap back quickly in the opposite direction.
Trend traders must keep this scenario in mind. In a fast-moving market, not knowing when a price reversal will appear is like playing Russian roulette. Even if you get lucky five times, when the hammer falls you are finished.
Newton’s First Law of Physics details that, "An object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force." This applies to trend trading. Trends have a natural bias to continue, which is why they are so predictable in nature as well as a reliable framework for trading.
However, the hard truth of trend trading is that at some point it ends. Worse, during its move it can lead to complacency on the part of the trader because it can lull you into believing that it will continue on its current path forever. The trader simply overlooks the consideration that the trend could end suddenly and abruptly.
Herds of traders fall victim to price reversals simply by the inability to read warning signs and make adjustments because they are not reading price accurately. This lack of skill can cause unnecessary losses, but, more than that, it can cause missing opportunities if a new trend begins to materialize.
Laying the foundation
A trend is price movement, plain and simple. As long as groups of people have gathered together to trade stocks, cattle, horses, real estate or any good, price trends will emerge. Price will then go up, down or consolidate between two price levels until an outside force enters the market to force one of those dynamic actions to change.
To analyze price movement, you must be able to classify it in one of three time periods: Short-term, intermediate-term and long-term. Short-term trends last from a few minutes to a few days; intermediate-term trends last from a week to several months; long-term trends last from several months to years.
In addition, trends will begin to form depending on whether the underlying security is under active accumulation or distribution (see "Market modes," below). Accumulation occurs when a stock or commodity is being acquired by a sufficient number of investors and the market reflects a gradual increase in price because of rising demand. This is indicated by a steady series of higher-highs and higher-lows.
Conversely, distribution occurs when a stock or commodity is being sold as a sufficient number of investors liquidate their holdings. That results in a gradual price decline as demand for it falls, leading to a steady succession of lower-highs and lower-lows.
If price is not exhibiting either of these behaviors — upward movement or downward movement — then it is consolidating in a trading range until an imbalance is created in either supply or demand, and will remain in consolidation until either the bulls or bears gain control and force a trend to emerge. The game changer then is where an external force, or catalyst, enters the market and changes the dynamic of the direction of the trend that will be revealed in the trend’s price action.
Defining the rules
The following rules act as a guideline to frame the terms or conditions in which a price reversal is likely to appear:
- Select the time period that you are trading in its respective time frame.
- Quantify the direction of that trend by drawing a trendline from key price levels.
- Identify breaks in trendlines and how price reacts.
First, define the time period that you are trading and identify the time frame that the trend is moving within. For example, if you are holding positions over a period of days to weeks, then you are trading an intermediate-term trend and wouldn’t need to track the price movement on the short-term or long-term time frames.
Second, draw a trendline on that time frame to quantify the trend in place. For bullish trends, you want to draw a trendline from the lowest low point in its price action to the highest low point. For bearish trends, draw a trendline from the highest low point in its price action to its lowest high point.
Finally, if price breaks through the trendline and the trend resumes but then fails to make a new high (if it’s a bullish trend) or a new low (if it’s a bearish trend), then the reversal has occurred and gets confirmed when the recalibrated trendline is breached after the failure.
Price consolidation does not warrant any type of defensive action unless price begins to make contrary high or low points in price’s opposite direction. This type of price action will trade back and forth between two relatively easy to identify price points where you can draw two horizontal lines until one side — bulls or bears — gains the upper hand and takes control of the trend (see "Breaking the trend," below).
NFLX fell below the first trendline in mid-June but without forming a lower low and went on to make a new high. On July 26, 2011, price again broke below the second trendline (formed by the previous breach) but formed a lower low on Aug. 8 and lower high on Aug. 12. This breaking of the trendline with a failure on the part of price to go on and make a higher high confirmed a price reversal and signaled that a possible new trend may be emerging. If you had held on to your entire position from the second entry of $128 to this signal to exit at around $221, your profit potential would have been 93 points a share, or just under 73% return. However, just as NFLX’s price action signaled an exit, it also indicated the potential for a new trend to emerge when lower highs and lower lows were formed. Price then offered two relatively easy entries as it broke through its 200-day simple moving average and pulled back on Aug. 31 and Sept. 7. In either case, you could have shorted the stock itself or bought put options for a directional move to the downside.
Static defense, dynamic offense
Once bullish price action breaks its trendline and fails to follow through, the corresponding price movement will reveal whether a new trend is emerging or whether it simply is a correction. Likewise, if bearish price action fails to follow through after a break of its downward trendline and begins a series of higher-highs and higher-lows, then a reversal to the upside is in play.
Your trendline acts as a static defense point that signals your next course of action in the event that a reversal is taking place. Price dictates your next move in the form of dynamic offense to trade the other direction.
Once a trendline is breached, it signals you to prepare for defensive measures in the likelihood that the current trend will end. Where a reversal is deemed possible, you could take partial profits, tighten your stops or hedge your position using options.
But the initial breach is only a warning flag. As much money has been left on the table by early exits as by hanging on too long. Take defensive measures, but wait for confirmation of a trend change before exiting completely, and for confirmation of a reversal before jumping on the other end.
Trends are easy to spot, but money is made by your ability to catch them early and to know when they end. Those two things are only identifiable in hindsight. The ability to interpret what price action is indicating can help you to better understand trends and their duration as well as distinguishing between corrections and reversals.
The key lesson is to let price dictate what you do next by being an interpreter of price in the present moment, not a predictor of what will come to pass.
Understanding market dynamics that lead to trend reversals will prevent you from being caught flat-footed by an unexpected market move or by bailing at the first sign of trouble. Your understanding of price movement is your defense against the unexpected that occurs in trading, while your ability to translate these three rules of price reversal into action serves as your offense to seize a trend that still is in its infancy.
Billy Williams is a 20-year veteran trader specializing in momentum trading of both stocks and options. Read his market commentary at www.StockOptionSystem.com.