This is J with a post today about the trend failure signal which is one of my favorite ways to trade counter-trend or reversal scenarios.
If you have been following my articles, you have probably realized that I am a KISS (Keep It Super Simple) investor in most scenarios and that includes following the trend in most of my trade decisions.
However, there are situations where a reversal opportunity has a high probability and certainly a positive Risk to Reward opportunity…
And when those opportunities present themselves I do not stick my nose up at them and declare “I am a trend trader” — Nope, I am a TRADER.
That means I take risks when the reward and the probability is substantial enough to justify it, and SOMETIMES reversal opportunities meet that criteria.
So with that said, let’s dive into my favorite counter-trend opportunity: The Trend Failure Signal
You may have guessed that this opportunity comes into play when a trend is evident, but FAILS to continue making higher-highs (Like I said, I keep things simple and straight-forward).
As you probably know, all market movement is made up of ebbs and flows in price change:
- When the market is trending up, the ebs and flows to the upside are greater and/or more frequent than those to the downside.
- When the market is trending down, the ebs and flows to the downside are greater and/or more frequent than those to the upside.
- When the market is in a range, the ebs and flows are about equal.
Many times, when it comes to reversal trading, people wait for a reversal:
Of course, the problem with that is that the reversal could well be over by that point in time and, even if it’s not, you’re about 65% likely to see a strong re-test from the reversal point that will stop you out of the trade.
Watch For Crazy Price Action to Indicate Trend Failure:
Traders typically get knocked out like this:
(I call these Pin Bar Wipe Outs but, often, they aren’t swift and abrupt like this one)
Selling a retest like the one shown above is a great strategy in itself, but it’s much harder than it looks to time retests, and there’s still a fairly high chance that it is not a retest, but rather a continuation of the prior trend.
Those can look like this, for example:
Both of these strategies–which some do, indeed, trade successfully–are a delayed techniques to trading reversals.
Now, being someone who does not believe in selling the very top and buying the very bottom, I am traditionally OK with delayed strategies. The reason being that I can become very wealthy by just grabbing 20 or 30 percent of a given move even if I am “late to the party.”
However, when it comes to trading reversals, I hate delayed techniques: The larger the delay, the more you exponentially reduce the Risk to Reward ratio of a reversal setup.
Let me show you how that works, going from earliest entry to latest:
What you can see is that even an average size candle moving down dramatically affects your Risk to Reward ratio. There’s an exponential relationship in the delay of your entry and the reduction for your R:R.
In my opinion, reversal trading is–by nature–not high probability trading so I want to hang my hat on Risk/Reward when trading reversal opportunities.
That’s where the trend failure strategy comes into play.
DISCLAIMER: This strategy is NOT an extremely high win rate strategy and it’s not meant to be.
The trend failure strategy gives you an early clue into what COULD be a reversal opportunity.
- Pro: The early opportunity presented makes for a great risk to reward (again, my key metric for reversals opportunities)
- Con: Early signals are often incorrect signals
Now, that I’ve done my best to lay out reasonable expectations for the setup, let’s dive into the signal itself.
When the market is ebbing and flowing in a systematic direction we have a trend (sometimes bearish and sometimes bullish).
The trend failure signal identifies one of those ebbs/flows in the midst of a trend that fails to produce a higher high in a bullish run or a lower low in a bearish run.
Typically, candlesticks are the best way to find these “trend failures” but a line or bar chart can certainly be used to identify them as well.
My favorite time frames to locate these are 15m, 60m and 240m candlestick charts. These often give an early enough signal to capitalize on yet are not such small moves (like 1m or 5m) that the follow through on a reversal is substantial enough to generate a good return.
Let’s lay out the things that must be in place BEFORE a trend-failure can take place
Balanced trend: The trend should be consistent and steady–not dramatic moves straight up or down
There must be a minimum of 3 higher highs or lower lows
The trend must cover significant ground within the last 3 highs or lows (not a slightly bullish or bearish consolidation)
Once you begin tracking a trend like the one described above, you can begin looking for a signal of failure.
This occurs when a leg begins to continue the trend, but cannot continue. In other words, when the leg becomes lazy after the prior legs have been strong and steady, we consider that leg to be a failure of the trend.
Here’s what it looks like:
Real Chart Example:
When you see a leg like this that is failing, you’ll begin looking for the entry point.
As with any strategy, there are different ways to approach your entry point, but my favorite is a retest of the failed high.
So, here is the failed high point:
We know this is a failed high because price has made other small tops and bottoms since reaching that point. In other words, it is more than just that candle failing to make a higher high.
This is NOT a failed trend:
The last thing you want to do is develop a quick trigger and think any slow-down in price is a failure and begin taking entries.
You can see that this strategy requires some patience, but once you get used to these lazy legs, you’ll be able to spot them with ease.
Once you’ve identified a lazy leg, look for a retest of the top of the leg.
***Sometimes a leg will APPEAR to be lazy but on the second retest (where you are looking to enter) price surges right through the zone and continues the trend. Looks like this:
This is clearly NOT a trend failure and that is why we wait for the candle to close BEFORE making an entry.
There are only two rules on the close before we can click the Buy or Sell button.
- The candle can not close significantly above the lazy leg’s high/low.
- The candle cannot be a major reversal and cause us to fall into the trap I mentioned earlier where we are trading a reversal AFTER a reversal.
In other words, as long as the candle does not go way up or way down and is an intermediate candle, we can go ahead and execute a trade predicting a reversal due to the failure.
The fun stuff: How to Setup your Trade
Because we are going out on a limb to predict a reversal, we are going to leverage that to maximize our Risk/Reward.
I recommend a Stop Loss that is about 1 ATR (average true range) above the lazy leg high or below the lazy leg low based on the time frame you are trading.
To determine ATR, just add the ATR indicator to your chart and you’ll get a value.
If you don’t have or do not want to use ATR, simply find a technical area that is above the high (or below the low) of the lazy leg and utilize it to hide your stop.
To set your Take Profit or Exit Point, simply target the origination of the lazy leg that you are trading for your first exit point (recommend exiting half of your position) and use a trailing stop for the remainder of the position with the ultimate goal of the reversal going to the origination of the trend:
I hope this article on using the Trend Failure was extremely valuable for you! If you’d like to check out another one of my favorite strategies, be sure to visit www.learntotradeforprofit.com/strategy and download my Stackable Carry Trade report!
Thanks again for reading and talk soon!