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How to identify trend reversals?

There is definitely something mesmerizing about identifying trend reversals.

Even the most powerful market trends come to an end.

They can do so in several ways.

Mastering the ability to identify trend reversals requires time and experience.

A trend reversal is a place on your chart where a directional move reverses and begins to trade in the opposite direction.

Indeed, it is a very lucrative tool to make money in the markets.

Why?

Because you are able to take advantage of a dramatic transition from a trend in one direction to a trend in the other direction without an intervening range.

You need to train your eye to recognize evidence of whether a specific asset is likely to encounter a trend reversal.

Numerous derivative indicators have been created that attempt to pinpoint reversal points. 

With practice and with the guidelines provided in this post, you will be able to quickly and easily identify trend reversals.

Oh and finally, we definitely don’t want to talk about MACD and RSI. 

It’s not a blog post designed to teach you how to take part of the herd.

Let’s start your education to be an alpha trader.

Table of Contents

The break in market structure to identify trend reversals

Market structure is like a simplified model where markets are always either trending or in trading ranges.

As a consequence, there are only three possible transitions for price:

  1. Breakout: A market breaks out of a trading range, and price enters a trend.
  2. Trading range: An established trend ends, and price enters a trading range.
  3. Trend reversal: An established trend ends, and price reverses into a trend in the opposite direction.

An established trend is a powerful force, like a tide.

So usually, trends take time to reverse.

Indeed, the supply and demand imbalance that created the trend must stop, find equilibrium, and create a new imbalance in the opposite direction.

It takes a lot of work, a lot of time, and a lot of contrary pressure to end that trend.

Having said that, let’s study the market’s structure behavior when a trend is about to reverse.

A 100% reliable tool to identify trends reversals

A trend reverses when a series (two or more) of pivots trend in the opposite direction.

You can understand what is a pivot in our previous post about price action and market structure.

  • In a downtrend:
    • We have a series of lower lows and lower highs.
    • When we start seeing a series of higher highs and higher lows, the trend reversal has occurred to an uptrend.
  • In an uptrend:
    • We have a series of higher highs and higher lows.
    • When we start seeing a series of lower lows and lower highs, the trend reversal has occurred into a downtrend.

The best risk/reward to enter the new trend is an entry at support/resistance, after the trend has confirmed its reversal.

What does it look like?!

First, let’s study the break in market structure.

A break in market structure of an uptrend
A break in market structure of an uptrend

The drawback of market structure to identify trend reversals

Taking profits from the previous trend right at the lower low that breaks market structure is definitely a bad idea.

Because you will leave too much of your unrealized gains on the table.

But if we consider entering an opposite position in the direction of the new trend, you will often be a bit late.

Why?! 

Because a trend reversal is a three-step process:

  1. First, a lower low is formed when we break the dashed line of the picture. 
  2. Then, an intermediate lower high is formed. This is what you can see on the picture right under, with a red arrow showing, the best short entry and the last take profit possibility if you did not sell prior to the reversal.
  3. And finally, the break of the support. 

If this method is 100% reliable, the main issue is that you will flip your bias after the price has already moved far away from the point of maximal opportunity.

break in market structure @subvertoxbt

The Victor Sperandeo trend reversal method.

How to draw a Vic Sperandeo’s trendline

In analyzing a trend on the chart, the most useful tool is a trendline.

Often criticized, the trendline can be a real edge if you know how to draw it properly.

  • For an uptrend:
    • Draw a line from the lowest low, up and to the highest minor low point preceding the highest high so that the line does not pass through prices in between the two tow points.
    • Extend the line upwards past the highest high point. It is possible that the line will go through prices past the highest minor high point. In fact, this is one indication of a change in trend, as will be demonstrated shortly.
  • For a downtrend:
    • Draw a line from the highest high point to the lowest minor high point preceding the lowest low so that the line does not pass through prices in between the two high points.
    • Extend the line past the lowest high point downward. 

Unclear?

Well, this is your first step to identifying trend reversals using trendlines!

But the issue with trendlines is that the drawing is subject to your own interpretation, even though you may have a strong and rigorous method to draw them.

Sperandeo’s trend reversals theory: Easy as 1-2-3!

For Victor Sperandeo, there are three basic changes in price movements that, when they occur in conjunction, define trend reversals in any market.

This trend reversal approach is a bit different from the one we mentioned for market structure.

It consists of:

  1. A trendline is broken. The prices cross the trendline drawn on the chart. 
  2. The trend stops making higher highs in an uptrend or lower lows in a downtrend.
    • For example, in an uptrend after a minor sell-off, prices will rise again but fail to carry above the preceding high point or barely break the high and then fail.
    • The converse would happen in a downtrend. This is often described as a “test” of the high or low point.
  3. Prices go above a previous short-term minor rally high in a downtrend, or below a previous short-term minor sell-off low in an uptrend. 

Step by step example of Sperandeo’s trend reversal method

Consider the case of an uptrend that is ready to make its trend reversal.

If prices cross the trendline, mark the chart with a circled 1 at the point of crossing.

If the price approaches, touches, or slightly breaks the horizontal line corresponding to the current high and then fail to carry through, mark the chart with a circled 2 at that point.

If the price carries through the horizontal line corresponding to the immediately preceding sell-off low, mark the chart with a circled 3 at that point.

If two out of the three conditions are met, the chances are good that a change of trend will occur.

If all three conditions are met, the trend change has occurred and is most likely to continue in its new direction.

After a little practice, you can learn to associate the three criteria of a change of trend visually and think of them in terms of 1-2-3:

  1. A break in the trend line;
  2. A test and fail of the preceding high or low;
  3. The breaking of a preceding minor rally high or minor sell-off low.

As easy as 1-2-3, the trend has changed!

Naturally, trading on these rules alone isn’t 100% effective-no method is.

One negative when trading by it is that by the time all three conditions are met, you sometimes miss a large portion of a price movement.

There are other observations, however, that can aid you in deciding to take a position much earlier.

This method is:

  • Too laggy for us,
  • And too subject to personal interpretation so it makes it hard to be consistent in the approach.

We definitely prefer market structure and ADX reading

But by now, you are able to spot the difference between horizontal market structure and diagonal trendlines by yourself.

ADX or the best trend reversal indicator

ADX to quantify trend strength from 0 to 100

The Average Directional Movement Index (ADX) was developed by J. Welles Wilder in his book, New Concepts in Technical Trading Systems.

ADX is derived from two other indicators known as Positive Directional Movement Indicator (+DMI) and Negative Directional Movement Indicator (-DMI).

The primary use of ADX is to measure trend strength.

ADX literally quantifies trend strength, trend velocity, and helps identify the strongest trends to trade and the weakest trends to avoid.

We refer to strong ADX trends as power trends because they move higher, farther, and faster than weaker trends.

A trader also reduces risk by trading power trends because they are less prone to deep retracements.

For instance, when entering long on a pullback in a strong uptrend, price is more likely to continue in the direction of the trend; so the trade is less likely to be stopped out.

ADX helps objectify our trend analysis.

We have all heard comments like, “that coin looks like it’s going higher,” or “that coin looks extended.”

These are opinions. 

ADX is objective.

It is more apt to say:

  • “ADX is above 25 and rising, so the price is likely to go higher,”
  • or “ADX is below 25 while the price is rising, so the trend may be extended.”

The magic ADX number for a trend to be designated “strong” is 25.

Once ADX rises above 25, the trader can use trend following strategies.

But when ADX falls below 25, the price is usually in a consolidation period, and trend trading strategies will normally fail. 

Have a look at the following table. 

ADX value and correlated trend strength
ADX value and correlated trend strength

How to sell tops using the ADX trend reversal strategy?

The primary use of ADX is to measure trend strength.

ADX is usually combined with +DMI and -DMI to make one indicator consisting of three lines, as shown in the bottom chart.

DMI determines trend direction and confirms entry and exit signals based on:

  • DMI+: bullish momentum
  • DMI-: bearish momentum

ADX will not solve all of your trading problems, but there is no better indicator with which to build a successful trading system.

ADX can answer many of your concerns about when and how to trade.

It provides a solid framework for understanding the larger context of trade.

ADX will help with the following trading decisions:

  • When is a new trend just starting to break out?
  • When is a trend strong enough to buy on pullbacks?
  • When is a trend getting weak and overbought?
  • When is a trend reversing?
  • When is a trend entering a consolidation?

ADX gives an objective value for trend strength, but the slope and patterns of the ADX line are also important.

Much can be learned about trend momentum by observing how the ADX line behaves during a strong trend.

ADX peaks can be compared to other ADX peaks, both during the trend legs and the retracements:

  • The higher the ADX reading, the stronger is the trend.
  • The lower the ADX reading, the weaker is the trend.

A trader should always keep trend strength in context with price action.

Low trend strength after a swing move may not be good if the trader is long and looking for a trend to continue.

Well, it’s not magic, it won’t always work but it gives you an objective way to catch trend reversals. 

Now:

  • Try to use the value shared in the previous picture and the pictures right under,
  • Compared ADX peaks value on this chart of Bitcoin.

Do you see how the macro trend was weakening and giving warnings of reversals?!

ADX cheatsheet to ride a trend from the beginning until the very end

ADX bitcoin trend ride with ADX

Oh, it looks like magic and we are scammers?

Well, just check these screenshots screaming to:

  • Buy the breakout when ADX is flat and price & DMI+ are experiencing a breakout.
  • Add to your position when ADX is squeezing while the price is consolidating under resistance.
  • Sell when ADX weekly and Daily is topping out.

After a swing, an ADX peak under 25 is your trend reversal signal

The most important thing to remember is: 

  • price swings with an ADX greater than 25 are strong enough for trend trading strategies.

  • price swings with an ADX below 25 are best avoided until a price breakout or continuation.

The 25 level for ADX must be placed in the context of the trend and price swings:

  • If the price has been in a trading range for two weeks and suddenly makes a new short-term high, then an ADX reading of 25 would likely indicate the beginning of a new leg in the trend.
  • But if the price makes a long swing up to a previous resistance level and ADX just reaches a level of 25, it would likely indicate that the trend reversal is very (very very) close. 

Think of ADX as the gas pedal for trends:

  • When ADX is rising, the gas pedal is down.
  • When ADX is falling, the gas pedal is let off.
  • When ADX is very high and rising, the pedal is to the metal.

Now, please, check the chart for ETHUSD.

It is a textbook example of how a trend can gather strength when the ADX is greater than 25.

See what happens next, when the ADX peak closes under or close to 25… 

Check out our Tutorial on How to Use the ADX on Youtube

ADX trend reversal signal on ETHUSD H4 right at ALL TIME HIGH

ADX trend reversal signal on ETHUSD H4 right at ALL-TIME HIGH

ETHUSD DAILY ADX PEAK CLOSE TO 25 in june 2019

ETHUSD DAILY ADX PEAK CLOSE TO 25 in June 2019

The "last gasp" trend reversals

A liquidity engineering “stop-run” to fuel trend reversals.

There is a trading rule that says, only half in jest, that the market will always do whatever will hurt the greatest number of traders.

After an extended run-up followed by a well-recognized topping formation, there will likely be many traders who try to short in anticipation of trend reversals.

Their stops are usually placed just beyond the recent highs…

At the same time, there will be traders who:

  • think they are smarter than the market, and who will be playing for trend continuation at these points.
  • missed the last upside move and experienced some fear of missing out

They too will buy, either on stops or with contingent orders when the market violates the previous high.

The moment of truth comes as soon as the market probes that area:

  • stops are triggered,
  • and the initial buying dries up.

Are there larger buyers there, waiting to bid the market higher with commitment, or was the whole move a fake-out?

If the latter, this will be obvious as prices fall back below the previous highs because:

  • Many of the shorts who were stopped out will reestablish selling pressure.
  • Freshly trapped longs will have to sell as well, whether they were holding established positions or entered on the breakout.

The result of all of this selling pressure is that the trend finally reverses.

From here, downside momentum develops as selling leads to more selling.

This is a special case of a failed test at the high of an old trend.

In the right context, it is an extremely reliable trend reversal pattern.

You can call this pattern differently considering who you want to honor the most:

  • 2B according to Vic SPERANDEO,
  • Swing Failure Pattern or SFP according to Tom DANTE,
  • judge swing according to Michael J. HUDDLESTON,
  • An upthrust according to Richard D. WYCKOFF.

Insights about the SFP pattern.

As a matter of fact, big players have to hunt stop-losses above/under a key swing high/low in order to generate the liquidity needed to fill their orders.

And to initiate trend reversals.

Smart money:

  • Pushes price up in order to trigger stop-loss orders, and fill their sell orders, which ends up creating a downside move and triggering a trend reversal.
  • Pushes price down in order to trigger stop-loss orders, and fill their long orders, which ends up creating an upside move and triggering a trend reversal.

An SFP will:

  • Usually occur on a minor high or low within one day or less of the time the high or low is made.
  • Usually occur on an intermediate high or low within 3 to 5 days or less of the time of the previous top/bottom.
  • Usually occur on a long term high or low within 7 to 10 days or less of the time of the previous top/bottom.

Basically, the SFP of a long term high/low is literally the maximal financial opportunity a market can offer you. 

Trading the SFP pattern is really worth the money!

The Parabolic Climax: The blow-off trend reversals.

The violent trend reversal of speculative bubbles.

Parabolic moves are dramatic and powerful.

They often exceed any reasonable limits that could have been imagined.

They seem to be the ultimate expression of a strong trend, but they carry within themselves the seeds of a dramatic trend reversal.

Let’s start with a definition.

A parabolic blow-off move into climax move is:

  • The pure expression of irrational exuberance.
  • Irrational exuberance is the psychological basis of a speculative bubble.
  • A speculative bubble is a situation in which news of price increases spurs investor enthusiasm.

It is difficult to initiate positions in these conditions, either with or against the predominant trend.

They also present challenges for traders.

The two biggest challenges are:

  • First, to recognize that a market is parabolic and take profit as later as possible to optimize gains,
  • And second, to stand apart from the emotional reactions of the crowd.

In both cases, a rigid technical discipline is the answer if you want to catch the trend reversals. 

Why?

Because if price can temporarily defy the gravitational tug of value, the hard laws of physics trump the soft science of crowd psychology. 

The farther prices rise above or fall below the asset’s fundamental value, the greater the store of potential energy to be released in the resulting disequilibrium.

“Markets can remain irrational longer than you can remain solvent.” John KEYNES
“Markets can remain irrational longer than you can remain solvent.” John KEYNES

Indeed, a bubble spreads by psychological contagion from person to person.

In this process, each person amplifies stories that might justify the price increases.

It results in a larger and larger class of investors.

Despite doubts about the real value of an investment, these people are drawn to it:

  • partly through envy of others’ successes
  • and partly through a gambler’s excitement. 

Here comes the explanation of how a euphoric climax is fueled.

Conditions fueling a speculative bubble

How to identify the trend reversal climax.

As we love Bitcoin, let’s study a buying climax considering the psychological elements we have described in the previous paragraph.

In the case of a buying climax, every buyer who wants to buy does so into the parabolic move.

These buyers are spurred by the powerful emotions that accompany such a move.

At this exact moment, the whole buying pressure has now been realized.

There is nobody left to buy: the last willing buyer just bought and there is no one left to buy.

How can you identify this situation?

It’s the easiest scenario to identify because you don’t even need to open your chart.

Several elements:

  • The insane acceleration of price in a highly volatile environment, like a “mania” stage where price upside moves look impossible to stop.
  • You feel it inside you because:
    • your euphoria of being rich takes over everything because you are making life-changing money.
    • And you start thinking to trade for a living, quitting your day to day job.

Please, don’t.

Then, you can use your chart to confirm the parabolic stage.

Every trend that eventually ends in a parabolic expansion begins life as a normal trend. 

It goes through the same normal stages of evolution as any other trend.

Unfortunately, it is usually impossible to identify good candidates for parabolic expansion early in the life cycle of the trend.

Typically, trends that end this way develop two characteristics: 

  • they last a long time,
  • and they accelerate into a steeper trend before the actual expansion.

In the Bitcoin example, we can clearly see the acceleration into steeper trends until the price action becomes unsustainable.

Indeed, this price action is unsustainable?

Why?

Please, just do the math and realize the money flow that has to consistently enter the market to sustain price.

As a matter of fact,  the market finally collapsed back into the vacuum… 

The price extreme reached in bitcoin’s 2017 parabolic move is a high-water mark that remains unchallenged for more than 2 years now.

It is common for the extreme points marked by these parabolic moves to represent long-lasting and significant elements of market structure.

Bitcoin btcusd parabolic blow-off into climax subverto

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