Day Trading

Top and Bottom Reversal Trading

Top and Bottom Reversals are among the easiest trading strategies. Day traders love using them because they have a very defined entry and exit point and a very high profit-to-loss ratio. In this section, I’m going to explain how to find reversal setups using scanners, how to read the Bollinger Bands to find extremes, how to use indecision or Doji candlesticks to take an entry, how to understand where to set your stops and your profit targets, and how to trail your winners.

If you are part of our private chatroom, you will hear me say time and time again that what goes up, must come down. Don’t chase the trade if it is too extended. The inverse is also true. What goes down will definitely come back up to some extent. When a stock starts to sell off significantly, there are two reasons behind it:

Institutional traders and hedge funds have started selling their large position to the public market and the stock price is tanking.
Retail traders have started short selling the stock but they will have to cover their shorts sooner or later. That is where you wait for an entry. When short sellers are trying to cover their shorts, the stock will reverse.

I’m going to illustrate this strategy with a few examples so that you can see exactly what to look for. Below is an example of what it looks like to find a stock that’s sold off really hard right after the market opens. Moves like this are extremely hard to catch for the short side, because when you find the stock, it is already too late to enter the short selling trade. But please, remember the mantra: What goes up, must come down. Therefore, you have the option of waiting for a reversal opportunity.

Example of a Reversal Strategy on EBS.

Each Reversal Strategy has four important elements:

At least 5 candlesticks (5 min) moving upward or downward.
The stock is trading close to or outside of the Bollinger Bands. Bollinger Bands are an indicator of volatility, and stocks usually stay inside of these bands.
The stock will have an extreme RSI indicator (Relative Strength Index). An RSI above 90 or below 10 will pique my interest. If you are not familiar with what an RSI indicator is, you can do a Google search or ask me in our chatroom. Your trading platform will probably have an RSI indicator built into it.

These three elements demonstrate that a stock is really stretched out, and you must pay close attention to the scan for all of these data points. You must simultaneously look for a certain RSI level, a certain number of consecutive candles, and a certain position within the Bollinger Bands.

When the trend is going to end, usually indecision candles, such as a spinning top or Doji, form. That is when we need to be ready.

In reversal trading, you are looking for one of these indecision candlesticks - spinning tops or Dojis. They are an indication that the trend may soon change. A Doji is a candle that has a wick longer than its body. You can see a picture of a bearish Doji below. It has that long upper wick that some would call a top and tail and that others would call a shooting star. This candle tells us four things: the open price, the close price, the high of that period and the low of that period. So, when you have a candle with a top tail, you know that at some point during that candle period the price moved up, was unable to hold at that level, and was then sold off. It depicts a bit of a battle taking place between the buyers and the sellers in which the buyers lost their push up. It is a good indication that the sellers may soon control the price and will push that price down.

The same is true about a bullish Doji. You can also see a picture of a bullish Doji below. It has that long lower wick that some would call a bottom tail and others would call a hammer. When you have a hammer candle with a bottom tail, you know that at some point during that candle period the price moved down, was unable to hold at those low levels, and was bought up. This indicates a battle between the buyers and the sellers in which the sellers lost their push down. It is a good indication that the buyers may now gain control of the price and push that price up.

Top Reversal Strategy with an indecision Shooting Star candlestick formed as sign of entry.

In reversal trading, you look for either Doji or indecision candlesticks.
They are an indication that the trend may soon change. In Reversal Strategies, you are looking for a clear confirmation that the pattern is beginning to reverse. What you definitely don’t want is to be on the wrong side of a reversal trade, or, as we call it, “catching a falling knife”. It doesn’t sound like a good idea in real life and it's not a good idea in trading. It means that when a stock is selling off badly (the falling knife), you don’t want to buy on the assumption that it should bounce. If the stocks are dropping, you want to wait for the confirmation of the reversal. This will usually be (1) the formation of a Doji or indecision candle and (2) the first 1-minute or the first 5-minute candle to reach a new high. That is my entry point. I set my stop at the lows.

In reversal trading, the RSI should be at the extremes (above 90, below 10), and that final candle should be outside the Bollinger Bands. Once you have your entry requirements listed, you must then look for an actual entry. An entry for me is going to be either the first 1-minute or the first 5-minute candle to reach a new high.

When you’ve had a long run of consecutive candles making new lows, the first candle that makes the new high is very significant. That’s my entry point. There are times when I’ll use the 1-minute chart, but typically I’ll wait for the 5-minute chart because it is a much better confirmation. The 5-minute chart is cleaner. The first 5-minute candle to make a new high is the point at which I get in the reversal, with a stop either at the low of the day or simply down around 20 to 30 cents. Usually, if a stock goes 30 cents against me, I will admit defeat, recognize that I mistimed my entry, and try again rather than continue to hold. At times, especially on stocks that are more expensive or more volatile, I’ll simply use a 20- or 30-cent arbitrary stop if the low of the day is too far away.

Once you’re in one of these trades, your exit indicators are quite simple. If the stock pops up and then suddenly moves back down on a bottom bounce, you stop out for a loss. If you jump in the stock and it ends up just going sideways, it’s a sign that you are probably going to see a flag (a reverse flag), and that is an indication that the price is probably going to continue to drop. If I get in and I hold for a few minutes and the price stays flat, I get out, no matter what happens after that. I may be wrong, but so be it, I don’t like to expose my account to the unknown. I need to be in the right setup, and if it is not ready yet, I’m out. If I get into the profit zone, I can start adjusting my stop, first to break-even, and then to the low of the last 5-minute candle. I will then keep adjusting my stop as I move up.

You must realize that almost all of the big moves will eventually be corrected. What goes up, must come down. In Reversal Strategies, one of the main advantages is the opportunity to watch stocks that are running up, while simultaneously calculating possible resistance points and areas that could provide a good reversal opportunity. This allows you to resist being impulsive and rushing into the trade. You can instead take your time to watch the trade develop and wait for the momentum to begin to shift.

An important metaphor many traders use when talking about Reversal Strategies is that of a rubber band. When stocks become really stretched out to the downside, then inevitably they’re due for a correction. So, when a stock is really squeezing down, you will know that at some point it’s going to make a bounce, and you want to be in there for the bounce. What you definitely don’t want to be is to be the one still selling. As I said before, that’s like “catching a falling knife”. If stocks are dropping, you want to wait for the confirmation of the reversal. This will probably be the first 1-minute or the first 5-minute candle to make a new high. That’s my cue to jump in. I set my stop at the lows.

Bottom Reversal

Bottom Reversal Strategy with an indecision hammer candlestick formed as sign of entry.

This beautiful illustration on Emergent BioSolutions Inc. (EBS) shows a perfect reversal that I found using my stock scanners. An indecision candlestick at the bottom of the downtrend signifies a potential reversal, and as you see right after that you see a big swing back up. I took this trade right after seeing indecision Doji, and kept my stop at the low of that indecision candlestick.

Example of a Reversal Strategy on EBS.

The biggest advantage of Reversal Strategies is that they overcome the difficulty of anticipating when stocks will make major moves. You will probably miss the moment when the stock starts to sell off, and you won’t have the time to short the stock for profit, but you can always prepare for the reversal trade.

Another example:

Example of a Bottom Reversal Strategy on ALR.

I found ALR (Alere Inc.) on June 27, 2016 at 10:57 a.m., using a software program that scans the stock market and lets me know exactly what I want to know. See the image below:

Example of my Bottom Reversal real time scanner for ALR.

My scanner, at 10:57 a.m., showed me that ALR had seven consecutive candles to the downside, a relatively low float (80 million shares) and a relative volume of 1.21, which meant it was trading higher than usual. I actually did not take this trade because I missed my entry, but I wanted to show you what overall trading strategies look like for bottom reversals.

When you’re looking at reversals, you want to make sure that you only trade extremes. The example we just saw was a stock that made an extreme move to the downside before that move reversed. A stock that’s been selling off slowly all day long usually isn’t suitable for a reversal. Instead, it’s helpful to think of stocks the way you think of rubber bands - you want to see them really stretched out to the downside or, for short selling, really stretched out to the upside. You want to see the big extension, which means that you want to see considerable volume. Once you do, you then look for a couple of key indicators that will suggest that the tide may be about to turn, and that’s when you take the position. I’ve said it many times: what goes up, must come down. Oftentimes these stocks will give up days’ and weeks’ or years’ worth of price gain in just a matter of minutes. It is very critical to be able to time the reversal.

I’ll say it again: the key to the success with top and bottom reversals is trading the extremes. How do I quantify these extremes? There are a few things I look for:

An extreme RSI above 90 or below 10 will pique my interest.
A candle outside of the Bollinger bands is also going to interest me.
Finally, seeing five to ten consecutive candles ending with an indecision candle or a Doji is definitely going to catch my interest. These candles usually show that sellers are losing their control while buyers are becoming more powerful, and that indicates the end of a trend.

I will add a caveat to that final point: there will be times when you will have five to ten consecutive candles without much price action. They may be drifting down slowly, but not quickly enough for you to sense that it’s a good reversal. You must look for a combination of these indicators all occurring at the same time. Never sell short just because the prices are too high. You should never argue with the crowd’s decision, even if it doesn’t make sense to you. You do not have to run with the crowd - but you should not run against it.

Utilizing all of these different factors will create the strategy that has been extremely successful for me due to its incredible profit-to-loss ratio. Your profit-to-loss ratio is your average winners versus your average losers. Many new traders end up trading with a very poor profit-to-loss ratio because they sell their winners too soon and they hold their losers too long. This is an extremely common habit among new traders. The Reversal Strategy, however, lends itself to having a larger profit-to-loss ratio. To return to the rubber band analogy, by following such a strategy you will always buy stocks when the rubber band is stretched as far as it can go. When you time this right, you’re in as the rubber band snaps back and you can then ride the momentum right back up.

To summarize my trading strategy for the Bottom Reversal Strategy:

I set up a scanner that show me stocks with four or more consecutive candlesticks going downward. When I see a stock hit my scanner, I quickly review the volume and level of resistance or support near the stock to see if it is a good trade or not.
I wait for confirmation of a Reversal Strategy: (1) formation of a bearish Doji or indecision candle, (2) candlesticks being very close or outside of the Bollinger Bands, and (3) the RSI must be lower than 10.
When I see the stock make a new 5-minute high, I buy the stock.
My stop loss is the low of the previous red candlestick or the low of the day.
My profit target is (1) the next level of support or (2) VWAP (Volume Weighted Average Price, described later in this chapter) or moving averages or (3) the stock makes a new 5-minute high, which means that the buyers are once again gaining control.

Top Reversal

A Top Reversal is similar to a Bottom Reversal, but on a short selling side. Let’s take a look at Bed Bath & Beyond Inc. as it traded on June 23, 2016. My scanner showed BBBY going up at 10:18 a.m. with six consecutive candles. It had a relative volume of 21.50, which meant it was trading significantly higher than usual. That was because, as discussed, retail traders look for unusual trading volume.

I took this trade and made a good profit on it. The candlesticks were not outside of the Bollinger Bands, but because it was trading with very unusual volume, and forming a nice Doji on top, I decided to take the trade. I shorted stock when a new 5-minute candlestick was made, with my stop being the break of the high of the last 5-minute candles. I covered my shorts at $43.40 for a 60-cent profit when the stock made a new 5-minute high.

Example of my Top Reversal real time scanner for BBBY.

Example of a Top Reversal Strategy on BBBY.

To summarize my trading strategy for the Top Reversal Strategy:

I set up a scanner that shows me stocks with four or more consecutive candlesticks moving upward. When I see the stock hit my scanner, I quickly review the volume and level of resistance or support near the stock to see if it is a good trade or not.
I wait for confirmation of a Reversal Strategy: (1) formation of a bearish Doji or indecision candle, (2) candlesticks being very close or outside of Bollinger Bands, and (3) the RSI must be higher than 90.
When I see the stock make a new 5-minute low, I start short selling the stock.
My stop will be the high of the previous candlestick or simply the high of the day.
My profit target is (1) the next level of support or (2) VWAP or moving averages or (3) when the stock makes a new 5-minute high, which means the buyers are once again gaining control.

Some day traders focus exclusively on reversal trades and actually base their entire careers on them. Reversal trades are certainly the most classic of the various strategies with a very high risk-reward ratio and, interestingly, you will always find stocks that are good candidates for reversal trades. I myself am trading more and more reversal trades these days, especially during late morning and afternoon trading. However, reversal trading is not yet the cornerstone of my trading strategies. I am more of a VWAP trader and Support or Resistance trader, which I will explain later.