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.