Day trading reversals are one of the most common and profitable strategies employed by traders across the world. In fact, due to their excellent risk/reward ratio, many base their entire careers on them. But if you’re looking at trading reversals, you want to ensure you only trade in the extremes. There may be times when you have consecutive candles but no price action. Alternatively, you may see a stock with an extremely high price, but this does not mean you should short it. Even though one of our favorite strategies at Bullish Bears is the reversal, you need to look for a few things first. Keep reading to see the criteria necessary if you want to trade this money-making strategy.
What Is a Reversal Trading Strategy?
A reversal is when the direction of price changes causing a trend to change. In other words, if price is moving down, finds a bottom, then heads back up, that’s a reversal.
This price action is the bread and butter of traders, both day and swing. Day trading reversals just help you find those directional changes that much quicker.
As a result, you need to know what to look for. Is it a fake-out? An actual reversal or a pullback? Stock market terminology can be tricky if you’re new.
It’s important to know charts and candlestick patterns instead of getting caught up in the minutia of terminology. When you can spot a tweezer pattern or star patterns, you know price is getting ready to move the other direction.
Day Trading Reversals and the Doji Candle
Let’s take a look at one of the most important Japanese candlestick patterns: The Doji. With a tiny body and long shadows, they’re hard to miss. Typically they form after a bullish or bearish trend. And when you see one, you can almost be sure, a price reversal is imminent. They’re great day trading reversals.
The opening and closing prices are the same, which means the market doesn’t know which direction to take. When you see this, there is indecision between buyers and sellers. It means the prior trend is losing its strength, and no one is in control of the market. Most often or not, if you see this after a strong upward or downward trend, the market is likely to reverse.
And when it comes to candlestick patterns, there are really only two types of outcomes: continuation or reversal. Either the current pattern and price direction will continue, or it will reverse. It’s as simple as that.
In other words, if the previous candles are bullish, you can anticipate the next one will be a bearish reversal. Alternatively, if the earlier candles are bearish, then the doji will probably form a bullish reversal.
As you can see in the example below the trend on the 5 minute chart was bullish. The ETF $SPY continues to make higher lows after aggressive intraday sell offs. Once the stock became oversold, and close to the 5 day exponential moving average, the day trading reversal happened. Meaning bulls bought the dip in the demand zones. Once the stock began to hit the “supply zone” sellers showed up, and the wicks show profit taking.
Day Trading Reversals With RSI
RSI tells us when to enter and when to exit the market by telling us whether or not it’s overbought, oversold, flat or range-bound. That’s a lot of information from a simple number! You can pair this indicator with day trading reversals.
RSI values range from 0 (bearish market) to 100 (bullish market). An RSI value of 70+ indicates that the stock is becoming overbought or overvalued, and a trend reversal or corrective downtrend can happen in the stock.
For those of you looking for a simple breakdown:
- When momentum is increasing to the upside, an overextension will lead the oscillator into the overbought zone, typically a value of 70. Theoretically, at this point, the traders will see the extension in price and begin to unload long positions. At this point, counter-trend traders will look to short the market as well.
- When price momentum is to the downside, the RSI can reach the 30 level, and at this point, theoretically, traders will see an oversold market and sellers will look to take profits. Other traders with other methods and thoughts about price will look to buy into the market.
Four Essential Elements of Each Reversal Strategy
- A minimum of five candlesticks moving up or down on a 5-minute chart
- The stock has an extreme 5-minute Relative Strength Index (RSI). When I say extreme, I mean an RSI above 90 or below 10. For clarification purposes, traders who trade reversals use RSI values to identify overbought or oversold conditions and to identify buy or sell signals. For example, an RSI value over 90 indicates overbought conditions. Contrastingly, an RSI value below 10 indicates oversold conditions. Luckily you don’t need to worry about calculating RSI values as your trading software automatically does this for you.
These two elements alone demonstrate a stock is stretched and ripe for reversal. What’s important is you’re able to identify these elements when day trading reversals. I recommend you set your scanner to alert RSIs higher than 80 and lower than 20. Once identified, you must be simultaneously looking for condition one – a minimum number of candles.
- The stock is trading at or near a significant support or resistance level. For example, you only want to take bottom reversal trades when the price is close to a significant support level. Likewise, you only want to take top reversal trades when the price is close to a major resistance level.
- An indecision candle. When the upward or downward trend is coming to an end, typically, you’ll see an indecision candle like a spinning top or Doji. In a nutshell, a Doji is a candle with a wick longer than its body.
How Can You Tell the Difference Between Retracement and Reversal?
When you’re looking for day trading reversals you don’t want to get them confused with a retracement. A retracement is a temporary reversal in price. However, if it’s a quick one, it can be profited on because you can scalp the move.
A reversal is a complete reversal of the trend. What was moving up is now moving down. And visa versa. Practice finding and trading reversals and retracements. If you use the Fibonacci to trade, you can use that to trade retracements. There are tools out there to help you trade well.
Don’t Be on the Wrong Side of the Trade
Have you ever heard of the term “catching a falling knife“? Well, if you haven’t, I’m sure you can deduce that it’s something you don’t want to do. When trading Reversal Strategies, you need crystal clear confirmation a trend is about to reverse.
And for those who don’t take the time to confirm the four criteria above and enter the trade regardless, we call it “catching a falling knife”; this is a bad idea, really bad. Please don’t assume that because a stock is heavily tanking (the falling knife), you should buy on the assumption that it will bounce.
As a trader, you must wait for the confirmation of the reversal. I’ll repeat it. You need an extreme RSI value, more than five consecutive candles in one direction with the formation of an indecision candle near a significant support or resistance level. Day trading reversals well depends on it.
If you’re looking to pack up your day job and start day trading for a living, or even on the side, then you’ve got a challenging but exciting journey ahead of you. You’ll need to wrap your head around the different trading strategies like day trading reversals. As well as an effective risk and money management approach.
Your profits will depend mainly on the strategies you employ. So, it’s worth keeping in mind that it’s often the straightforward strategies that prove successful. With Bullish Bears, we teach you simple strategies like how to day trade reversals. Join us now.