Trend trading is one of the most common strategies among novice traders. Its difficulty is determining the moment of a potential reversal, before which the trader must close the position or, vice versa, immediately enter the market at the beginning of a new trend.
A trader should understand that this is a reversal, not a correction, and they can use tools such as reversal indicators, divergence, patterns, or pivot points. In this review, you will learn how to use these tools and what their advantages and disadvantages are.
How to predict a trend reversal: an overview of analysis tools
What could be simpler and more effective than trend trading? It would seem that you just need to encounter a strong movement, stock up on capital to withstand small local reversals, and watch the deposit grow. But in practice you are sure to stumble upon several questions:
I will try to answer all these questions in this review by introducing the basic tools for determining potential trend reversal points. Some things are from personal experience, others from trading forums and blogs. I welcome any criticism and comments in the comment section of the review.
Trend reversal point forecasting tools
A strong trend is a significant market dominance of either seller (a growing trend) or buyers (a falling trend). At some point, the number of traders of the prevailing party and the volume of their positions is reduced, the price slows down until the moment of equilibrium. At that moment, when the weaker side turns into the stronger side, a reversal occurs. The trader’s goal is to predict and use this moment for their own purposes.
1. Technical analysis reversal indicators
There are hundreds of reversal indicators and each of them works according to its own principle. I will not analyze examples in detail, I will only describe groups of such indicators in general terms:
Oscillators. Reversal indicators that identify overbought and oversold zones. If the oscillator is in the overbought zone, it reverses and prepares to exit it, then we can talk about a potential change in the direction of the current trend.
It is important that the indicator exits the zone as close as possible to a 90° angle with respect to the horizontal border of the zone. Examples: Stochastic, RSI, DeMarker.
Channel indicators. In theory, the price aims to reach its equilibrium value, i.e. the state of balance between supply and demand. When it moves away from its average value, the balance is violated, but sooner or later, the price comes back again.
The amplitude of price fluctuations forms a channel, and most often reversals occur at the borders of this channel. Examples of such indicators: Bollinger Bands, Donchian Channel.
Classic simple indicators with different periods. Most often, moving averages (simple, exponential), stochastics, etc. are used. Determining the pivot point is basically waiting for the moment when all the lines converge together, after which the trend will reverse and the indicators will diverge.
Examples of such strategies with Stochastics (Spud’s thread), MA, Alligator, and Anti-Alligator are described in this review.
Remember that indicators are just algorithms built on a particular mathematical formula. They have many shortcomings: they lag and do not take into account the fast-changing character of the market situation, i.e. the illogical actions of big capital owners.
They are constantly improved, various smoothing models are used, but this does not significantly affect the signal performance.
Therefore, be careful when relying on the signals of reversal indicators: double-check them on other timeframes, compare with the data of other tools - in a word, do not be afraid to experiment. Finding an accurate trend reversal indicator is not so easy.
Divergence is the discrepancy between the technical indicator and price direction. In other words, the indicator shows that the market is overbought and moves down from the signal zone, while the price, on the contrary, continues to grow.
The reason is that the indicator leads and the price is inert, so it reverses immediately after the indicator. Divergence is an additional but stronger signal that predicts a reversal. All that is left is to notice it in the chart. This is not always easy though.
The most common strategy described on many forums is the search for divergence using RSI, MACD, and slow stochastics. But there is an opinion that RSI is not suitable for finding discrepancies, so you will have to try yourself.
Question to professional traders working with divergence: what indicator would you recommend, and what are the optimal settings and timeframe?
Divergence is not for everyone as too many nuances must be taken into account that can otherwise lead to an error. You should only use it in a live account when you have a trained eye to see it instantly. If you still need to build lines and double-check everything, perfect your skills on a demo account.
However, you can go the simpler way: why draw lines if you can use ready-made combined tools? One of the most popular indicators in trading circles is the Divergence Panel. You can download it here, installation is standard (if you need help, leave a comment below).
Divergence Panel is an information panel with buy and sells signals for all currency pairs and timeframes. In the archive downloaded from the link above you will see another file - Divergence Solution.
It is a modified MACD without an additional moving average. Divergence Panel was created based on it. These two indicators are pretty much the same, the only difference is in the output format. I would use the Divergence Panel as the main divergence indicator, but you should open Divergence Solution too.
The indicator is interesting in that it analyzes all the standard timeframes of the main currency pairs. Its settings allow you to analyze any combination of pairs and timeframes. The indicator has more than 20 settings, so it is better to leave them unchanged for testing. They are for ZigZag, RSI, EMA, and ATR indicators, which are also in the Divergence Panel.
False signals are quite common, but this is only if you follow the recommendations of the indicator blindly. For example, the last recommendation for a short position with a stop loss at 0.8 and take profit at 0.29 seems more than strange. However, the trend direction after the indicated entry point in both cases really turned out to be true, although small.
It all depends on the goals. If you do not use leverage and set long stop orders, then, for example, the first signal could have given you an opportunity to earn not only on the first short upward movement (the first 20 candles) but also the long one (close the long position at the moment the second downward signal appears).
Here in the screenshot, you can see the chart after the second signal. Divergence really worked, but only in the short term. While in the previous case after the first signal we could leave the position for several days, here it must be closed at the level marked with the yellow line.
Signals are not frequent - sometimes you have to wait several days in the M15 interval, but this is better than nothing. I recommend not focusing on the proposed levels for placing orders and closing the positions earlier without leaving them on their own.
Also, pay attention to the convergence angles of the indicator lines. The more the lines in the price chart and in the Divergence Solution are directed towards each other, the stronger the signal.
For example, in the first screenshot above, the signals are weak: in the first case, the line in the price chart is almost horizontal, in the second - the line in the indicator is almost horizontal. Therefore, the price movement after the reversal is weak Continue reading with Litefinance.com...