In our earlier article “What Really Drives Price Action in the Financial Markets?,” we discussed the concept of liquidity being consumed by market orders and how this is the prerequisite for any price move. In this article, we’ll follow on from that and consider HOW a reversal occurs.
A huge proportion of traders are focused on trading reversals. Usually there is some method of setting levels at which a reversal may occur; Support & Resistance, value areas, volume profile, pivot points, and Fibonacci are all commonly-used methods of setting locations where a reversal may occur.
There is nothing inherently wrong with trading reversals but it is worth considering WHY traders are attracted to reversal trading and what the downsides may be.
Pros & Cons of Trading Reversals
Reversal trades are attractive for a number of reasons. If you trade a reversal, you stand to benefit from a larger move. A day trader may see a market moving down and attempt to buy the low of the day in the hope of selling at the high of that day. In that case, the whole daily range is the theoretical potential for that trade. The stop loss on a reversal trade is usually obvious and visual. It’s just the other side of the reversal level. So it becomes an easy trade to handle visually. It seems like a more natural way to trade and manage those trades.
There are some downsides to trading reversals, however. First of all, the very nature of a reversal is that you are trading against momentum. It’s “easier” for a market to carry on doing what it’s doing than it is for it to do something different. Not all reversals are equal in this respect. I like to consider reversals as major reversals and minor reversals.
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