Defining a reversal

In my last article I defined a superb trading strategy called Reverse Divergence strategy. Let me very briefly recap it for you: You trade in the direction of the trend, defined by a 50 period MA, and when the Stochastics indicator has made a lower low, but price is making a higher low, you have a BUY setup.

The discerning day or swing trader will naturally ask when you buy? Do you just buy indiscriminately, or do you wait for some sort of confirmation? How can you increase your chance of success for this particular setup?

There are several solutions and I will discuss a couple of them here. One of them is pro-active, while the other is reactive. The difference comes down to risk vs. reward.

If the Stochastics indicator is making a lower low while price is making a higher low, you as a trader are on the alert for a reversal back in the direction of the trend, and you are looking to buy. One solution is to watch the key Fibonacci levels, such as the 61.8% or 78.6% retracement level. If you can get into the market at a “Fib” level, while Stochastics is setting up a Reverse Divergence, you are looking at a strong set-up, with small risk.

The other entry method is to wait for confirmation. By doing so, you will essentially wait for the market to move back in the direction of the trend, but you will by its very nature not be in at the turn. I use what is known as a 4-bar fractal on my chosen time frame. A 4-bar fractal reversal is a solid set-up, but it will never get you into the market at key levels. The definition of it is to look at the last 4 bars in your time frame, and when the current bar closes above the high of the previous and the 4th bar, you have a BUY signal.

Happy Trading

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