From the January 01, 2012 issue of Futures Magazine • Subscribe!

How to identify price trend reversals

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.

Trend physics

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.

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