All trend reversals begin as a potential trend retracement. Remember, a trend retracement always precedes continuation of the predominant trend. However, a trend reversal never precedes the continuation of a trend. If a trend reverses, a new trend is instituted. An uptrend reversal consists of a subsequent downtrend. A downtrend reversal consists of a subsequent uptrend. An uptrend or downtrend converting to a sideways trend is not considered a reversal.
For an uptrend to reverse, buyers and sellers must exchange power; selling continuously exceeds buying. If selling pressure fails to continuously exceed buying pressure at lower and lower price levels, there can’t be a bearish reversal.
For a downtrend to reverse, buyers and sellers must exchange power; buying continuously exceeds selling. If buying pressure fails to continuously exceed selling pressure at higher and higher price levels, there can’t be a bullish reversal.
Generally, a reversal in market sentiment precedes a reversal in price.
An uptrend or downtrend converting to a sideways trend is considered a period of consolidation. When the phase of consolidation ends, the predominant trend should continue. If a phase of consolidation persists for a prolonged period, it is no longer considered consolidation. Instead, it is simply considered a sideways market. Many traders consider a “sideways market” and “consolidation” synonymous. It is important to keep the two distinct.
The word “consolidation” implies that an occurring action or process makes something stronger. A secondary definition of the word consolidation implies that an action or process combines several things into a unified more effective whole. Therefore, consolidation should precede the continuation of the predominant trend. If a phase of consolidation precedes a trend reversal or prolonged sideways market, then we cannot logically consider the sequence of price movement to be consolidation. During a trend, if prices trade sideways for a transient period before continuing the trend, we should consider the sideways price movement as a phase of consolidation. During a trend, if prices stall and trade sideways for a prolonged period, we should not consider the price sequence as consolidation. Instead, we should interpret the price sequence as an extended period of indecision and equal force between bulls and bears. During a trend, if prices stall and subsequently reverse, we should not consider the sideways price sequence as consolidation. Instead, we should attribute the sideways price sequence as a reflection of trend exhaustion and weakness. As a result, the opposing force (bulls during a downtrend, bears during an uptrend) reclaimed control of the particular market.
Let’s look at an example of a bearish reversal.
Figure 1.1 shows an uptrend converting to a downtrend; a bearish reversal. In real-time, the initially marked trough may be perceived as a bearish retracement. However, buyers did not regain control of the market intermediate to long-term. The particular market continued to decrease in price. We can identify the downtrend by analyzing descending peaks and troughs.
Later in the book, we will learn how to implement techniques, methods, and indicators to discern a trend reversal from a trend retracement.
Figure 1.2 shows the variance between a bearish retracement and a bearish reversal.
Figure 1.3 shows the variance between a bearish retracement and a bullish reversal. Notice how each bullish retracement precedes the continuation of the predominant downtrend. However, the bullish reversal constitutes a change in the predominant trend; bearish to bullish.
We can use the retracement tool to distinguish a retracement from a reversal. It’s in our best interest to consider a prices move more than 66% against the predominant trend a reversal. A 33 – 66% price move against the trend is a retracement. A move less than 33% is a pullback. There isn’t a hard rule when it comes to classifying a price sequence as a reversal, retracement, or pullback. However, a pullback and retracement always precede continuation of the trend. A reversal constitutes a new trend entirely.
A trend reversal should leave no doubt as to whether the preceding trend has ended.
Novice analysts should refrain from trading a counter trend price move until they can definitively conclude the trend is over, a new trend has instituted, and that new trend is exploitable.
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