One of our favorite strategies is the Reversal Day Trading Strategy. This Strategy Complements our Momentum Day Trading Strategies.
We apply the Reversal Strategy for both Day Trading and Swing Trading.
The primary reason I like our Reversal Day Trading Strategy is because it gives us the opportunity to enter a stock very close to support.
You may have heard the sold saying, buy low – sell high. Well this is certainly easier said than done.
As traders we want to find the opportunity to take a position on a stock near a support level. This gives us a good place on the chart to set our stops.
What is a Reversal Day Trading Strategy?
At its simplest, a reversal strategy aims to profit from the reversal of trends in markets. If the S&P 500 has been rallying for months, and a trader spots a signal that a sell-off is coming, then they are aiming to profit from the reversal of that bull trend.
Most of the time, when a trend ends, the market ends up consolidating in a range for a period before a new trend begins.
At the end of an uptrend, you typically see a loss of steam and volume, as well as lower highs before the market settles into a tight range. It’s commonly after the downside break of this range that we see the actual “reversal” that many traders are looking for.
Here’s what most trend terminations look like:
I didn’t pull this theory out of a hat. It’s supported by not only one of the most respected technicians in history, Richard Wyckoff, but also has been validated through gigabytes (in .csv!) of extensive research by Adam Grimes. He didn’t just study S&P prices, he has tested his patterns on “Equities in the 1700-1800s, grain prices in Europe in the 1300s, and, perhaps to the point of absurdity, to the price of dates and barley in ancient Babylon!”
With that out of the way, this brings us to Richard Wyckoff and his concept of the Market Cycle.
Wyckoff’s market cycle has four stages: accumulation, markup, distribution, and markdown. See the graph below for a visual representation.
The premise behind the Wyckoff’s Market Cycle is that “smart money” manipulates the market so they can as early as possible and sell to the “dumb” retail money at just the right time. This ensures that retail is always holding the bag, and smart money captures the meat of the move.
At the core of this theory is that the market is that a few “Composite Operators,” highly informed traders and investors, almost completely control price and move the market at their will.
Accumulation is when the market is forming a base, supported by the quiet and careful buying of smart money.
On a price chart, accumulation looks like the market is trading in a range, mostly going nowhere. However, the Wyckoff practitioner can observe the subtle signals that smart money is buying.
Markup is when price breaks out of its accumulation range and enters an uptrend. According to Wyckoff, at this point, the composite operators have sufficiently accumulated their position. They are now ready to allow the market to auction higher, by essentially attracting the dumb money with a breakout.