By Rob Colville on January 22, 2016 in
So much of being a trader is about finding your identity, and in a way, pledging your allegiance to a certain “school” or faction. For example, choosing technical trading instead of fundamental, or longer-term trading instead of intraday. For some, it even means choosing between trend trading and reversal trading for fear that they can’t successfully do both.
The fact is, however, that traders don’t have to choose between trend trading and reversal trading. It’s good to do both, and while the two disciplines have their differences, developing your strategy to accommodate trend and reversal trading will likely enable more success and profitability over the long term. Here’s why…
Most anyone in the trend trading camp will cite relative safety and risk aversion as key reasons for trading that way. By their very nature, trend traders prefer to take small bites at the market, and to trade in its prevailing direction. They “buy dips and sell rips,” all as part of a straightforward trend trading strategy, which quite honestly worked like a charm in 2015.
All past and future results aside, though, trend trading offers these distinct benefits over reversal trading:
Higher Probability – With momentum on their side, trend set-ups have a higher probability of working out—often much higher, in fact—when compared to any reversal trading strategy
Higher Frequency – Because trends are longer lasting, trending set-ups naturally come along more frequently than reversals, which occur sporadically and typically only when price reaches major support or resistance
These factors and others could cause trend traders to avoid reversal trading altogether. Instead, they’re simply willing to win (and lose) small and trade with repetition. And while that may sound fine, this is the tradeoff, and the potentially game-changing reason why even devoted trend followers should be trading reversals, too:
Unlike traditional trend trades, reversal set-ups are all about taking a calculated risk in pursuit of a higher reward. But make no mistake, this isn’t a reckless gamble or an attempt to chase some unproven or ill-advised set-up. Reversal trades, when they work out, win big, and we’ve got a recent example in GBPCHF that proves why, despite the lower probability and higher risk, reversal trading makes an excellent complement to a steady diet of disciplined trend trading.
As seen on the chart above, a classic double-top formation appeared on the daily chart of GBPCHF back in late-December. A bearish pin bar reversal seen at the long-standing range high helped cue us into this short trade, and the immediate and decisive downside move that followed has now resulted in an explosive gain of about 30% in just a few weeks!
The key takeaway from this isn’t the excellent reward potential, though, it’s this: Reversal trading works with our standard trading methodology, yet produces exemplary profits that simply aren’t typical of trend trading. That’s why reversal trading is a worthy component to most any trading strategy, not an opposing methodology that trend traders should avoid.
Have you ever felt the exhilaration of a trade that quickly goes 10%, 20%, or even 30% or more in your favor? If you’ve been focused solely on taking run-of-the-mill trend trades, then it’s likely you haven’t! In part, that’s why we don’t support the “Trend Trading vs. Reversal Trading” debate, and choose instead to view them as complements to one another, and not polar opposites that don’t mix.
So the next time you spot a potential reversal opportunity, apply your usual rules for trading and entry, and if that set-up qualifies, take it! Reversal trading requires guts and conviction, but as soon as one of these low-probability, high-reward set-ups goes in your favor, you’ll see for yourself—like we did most recently in GBPCHF—that it’s a calculated (and manageable) risk that’s well worth taking in the name of more profits and better overall performance.