Spotting Trend Reversals

February 22, 2008 at 11:25 am · Filed Under Educational 

A wise man once said, "He who trades against momentum will end up broke and homeless."  Okay, actually I made that up, but it is a wise piece of advice to follow.  If you don’t want to trade against the trend though, how do you ever get in on value stocks (or short overbought stocks)?  I’ve talked about trading breakouts before, which is great in a bull market where lots of stocks are at their highs, but what is one to do in a weaker market when lots of good stocks are significantly off their 52 week highs?  That’s what I’m here to talk about today.

First up, a simple definition of a trend is in order.  For our purposes, a trend is merely a series where the extreme points of the price range move in the same direction.  If you read my daily posts, you’ve probably noticed that I mention higher highs and lower lows a lot, and this is what I’m referring to.  A picture is probably easier to understand, so take a look below and follow the green dots, which are the peaks of the upward movements, and take note of how each one goes lower till October.  Then follow the red dots, which are the lows of the downward movements, and observe how they also go lower.

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If you would have tried to buy value on the slide down, there would have been no way to know how much you would lose before the stock turned around.  It’s obvious now that you can see the whole chart, but put your hand over the right side of the chart starting at August.   Keeping in mind that the fundamentals were solid throughout this whole period, don’t tell me you wouldn’t think that 58 wasn’t cheap at the time.  Although PNRA found support around 50, there’s a decent chance that the market could have hit a rough patch or that some unexpected events could have hit the company and sent this one down below 40.

So let’s say I really liked this company and determined that I wanted in after it started getting sold off in July.  Rather than running out and buying it right away, a wise man would have waited first for the trend to reverse.  A reversal is simply when the stock changes from making lower lows and lower highs to making higher lows and higher highs.  So as I followed this stock through the summer I would have been glad that my money wasn’t tied up in a losing stock, and I also would have been looking for the first higher high or higher low.  Often times stocks will tease by moving to a higher high or a higher low, only to reestablish the trend with a lower mark on the opposite side.  Keep your patience through these periods and wait for both the higher high and the higher low. 

At the very end of September I would have noticed that a marginally higher low was established.  Depending upon how aggressive I was, I would have either bought after the stock established that it would make a higher high above 54, or I could have waited for the definitely higher low at 52 before buying, where I also would have gotten in around 54 in this case.  Since this stock had a fairly wide trading channel, the stop below the low at 49, or a 10% loss, would have been a little larger than hoped for, but not unreasonable.  Waiting for the reversal would have saved me 3 months and whatever extra I made by getting the even more discounted price. 

As we wind down, I’ll also remind you to match your chart period to your up and down wave period and to match that to your investment time frame.  You’ll want to have at least 5 bars between waves on average, otherwise you’ll have too many reversals showing up that are on a shorter time frame than you’re trading.  On the above daily chart, the points are mostly 1 to 2 weeks apart since I was looking at a longer than one month investment.  By now you may realize that even while trading reversals you’re looking for breakouts on a much smaller scale.  Summarizing this entire post: you will NEVER be able to pick out the absolute bottom of a drop, so don’t even try.  Now the only thing that’s left to do is to find some oversold stocks.

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