Trend Reversal and Trend Continuation Strategies Explained

In this article, we will discuss

Trend Reversal and Trend Continuation Strategies Explained - Banner

If you had to simplify entering the market and initiating a trade for a 5-year-old, it would probably go something like this — when the prices are rising, attempt to buy and leverage the increase, and when the prices are falling, attempt to sell and pocket your gains. Fundamentally, this is what short-term trading in the market is all about.

Technical analysis aims to help you identify the current trend — which may be bullish (upward-moving) or bearish (downward-moving). It can also help you understand whether the market is currently giving a buy or a sell signal. This depends greatly on whether the prevailing trend may continue or whether it may be due for a reversal.

So, any trading strategy you implement should factor in the possibility of trend changes. In this article, we take a closer look at what trend trend reversals and trend continuations are and how you can trade in these scenarios.

What is a Trend Reversal?

A trend reversal or a trend shift is a phenomenon where the price of a stock or security changes direction entirely. Reversals can be bullish or bearish, depending on the direction of change. A bullish reversal occurs when the price, which was originally falling, starts to rise. Conversely, a bearish reversal occurs when the price, which was originally rising, begins to fall.

These points of reversal can be prime areas to enter a new trade or close an existing position. For instance, if you are currently long on a stock, a bearish reversal may be the ideal time to exit that position and enter a new short position instead. That said, some reversals may be false signals where the price appears to change direction, only to reverse once more and continue in the original direction again. If you want to leverage a potential trend shift in the market, make sure you set a tight stop-loss to account for such potentially misleading signals.

What is a Trend Continuation?

A trend continuation is a phenomenon where the prevailing price movement shows a tendency to sustain itself over the next few trading sessions. For instance, if the price of a stock is falling, you can rely on certain technical indicators to establish the momentum of the price dip and assess if the decline will continue further for a few more trading sessions.

Sometimes, the price may retrace or pull back slightly in the opposite direction before continuing in the direction of the original trend once more. This may often be mistaken for a trend reversal, when, in fact, it is only a minor consolidation that occurs before the price continues to trend strongly in the same direction again.

Identifying a trend continuation is just as important as spotting reversals. This is because knowing a prevailing trend may continue helps you avoid exiting an open position hastily or too early. Additionally, it also gives you opportunities to capitalise on the building trend further, before a reversal occurs.

How to Trade a Reversing Trend?

When you anticipate a 180-degree change in the ongoing trend, you need to prepare for a reversal. By implementing a strategy to capitalise on the reversal immediately after it occurs, you can get a head start in the new trend and enter the market (or close an existing trade) at an opportune moment. Let us look at some effective trend reversal strategies you can use.

  • Fibonacci Retracement Strategy

You can use Fibonacci levels to identify potential price reversal points for a stock or security. To do this, you need to draw Fibonacci retracement lines between the high and the low points of a prevailing trend. Then, pinpoint the primary Fibonacci levels like 78.6%, 61.8%, 50%, 38.2% and 23.6%. These are the points where reversals can be expected. At these distinct Fibonacci levels, you can look for technical indicators and/or candlestick patterns that may indicate a market reversal and trade accordingly.

  • Swing Trading Strategy

Swing trading helps you capitalise on trend changes, so you can enter the market at the beginning of a reversal. Using technical indicators like moving averages, RSI, Bollinger Bands and stochastic oscillators, you can identify the ranges for the price swing and prepare for reversals at the high and low points expected. You generally enter the market with a long position when the reversal is due at a low point (and vice versa). Thereafter, you hold the position for several days or weeks to capture the momentum shift.

  • Counter-Trend Trading

The counter-trend trading strategy could be risky because you essentially take a position against the prevailing trend. The entry for such trades is based on identifying overbought or oversold conditions using technical analysis. Indicators like RSI and stochastic oscillators can help you with this. When these indicators signal potential exhaustion points in the current trend, a corrective wave may be on the horizon. So, you enter trades in the direction opposite to the prevailing trend.

  • Candlestick-Based Trading

Aside from technical indicators, candlestick patterns can also help you identify and capitalise on trend changes early on. Some patterns occur over several trading sessions, like the head and shoulders pattern, which is a sign of a bearish reversal. Meanwhile, others may occur over just one or two sessions at most, like the bullish or bearish engulfing patterns and the hanging man.

These patterns are all lagging indicators because they can only be identified after they are formed. So, if you plan to capitalise on a reversing trend based on candlestick patterns, you need to wait for a session or two to confirm the shift before entering the market.

How to Trade a Continuing Trend?

Trading a continuation is often harder than trading a reversal because you cannot easily assess how much the existing market momentum can sustain the prevailing trend. Nevertheless, some strategies can help you successfully enter the market and earn profits when the prices are moving steadily in any one given direction. Here is a closer look at some such trend continuation strategies.

  • Pullback Entry Strategy

A trend may sometimes continue after a minor retracement or pullback. For example, if a falling wedge pattern occurs in the middle of an ongoing uptrend, it may be a sign that the price may dip slightly before breaking out past the resistance level in the wedge and ascending again. You can also use tools like moving averages to identify when the price has deviated from its original path but is likely to resume the previous trend. For instance, you could buy on a dip in an uptrend, when the price approaches a 50-day or 100-day MA.

  • Trendline Trading

To implement this trading technique, you must first identify the highs and lows of the price movement during the prevailing trend. Thereafter, draw trend lines along these high and low points to identify the support and resistance levels for the stock. You can then enter a new trade when the price tests a trend line without breaking it — which is often an indicator that the current trend will continue. However, ensure that you use technical analysis tools like RSI and MACD to test the strength of the continuing trend.

  • Breakout Trading

In breakout trading too, you need to first identify the support and resistance levels currently prevailing in the market. Thereafter, if the price tests either of these trend lines and breaks out in the direction of the current trend, it is a signal that the price movement is likely to strongly move further in the same direction. For instance, if the price of a stock breaks past the resistance in a bullish market, you can expect the upward trend to continue. Based on this information, you can enter or exit a trade as needed.

  • Pyramid Trading

This is a more advanced trading technique where you consistently add smaller positions in the direction of a winning trade as the current trend continues. For instance, if the price of a stock is rising, you buy more shares in the company in small batches as the price continues upward. This helps compound your profits while simultaneously managing risks. Each new position should be smaller than the previous one to ensure that the risk is not magnified. If a reversal occurs, you can exit all these positions and clock in the profits.

Conclusion

This sums up what reversals and continuations of a trend are — and how you can use different strategies to trade in each of these phases. The trick to making these strategies effective is to interpret the signals and indicators accurately. Once you’ve done that, you also need to set appropriate stop-loss limits for each trade. This will ensure that if the price moves in a direction opposite to what you expect, you are still protected to a certain extent.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING.
The asset classes and securities quoted in the film are exemplary and are not recommendatory.
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