How to Spot Reversals Before they Happen
Updated: Oct 16, 2020
This is one thing that I have struggled with personally, and I am sure that all of you perma-bears and counter-trend traders out there can relate! The question is, how do we spot reversals before they happen? Well, you're about to find out.
Let's step it back for a moment, however. What is the market's job, exactly? To be frank, to bring buyers and sellers together - that's it! It's job is to create transactions. Just like a grocery store, it's job is to put out volume (meaning sell products); if the grocery store isn't selling anything, then it may need to change prices in order to get more people interested.
Price is an advertising function of the markets. Whether you are trading stocks, options, futures or forex, price is the underlying mechanism around which we trade. Volume serves as a confirmation; when volume begins to dry up (like the grocery store) prices may need to auction higher or lower, in order to fulfill more transactions. Another fantastic example is at an art, or cattle auction. For instance, the auction might open up "Do I hear 25?" - no response. "Do I hear 20?" Someone responds by raising their hand, "New bidder!" In this instance, there was no volume at 25, so the market had to auction down (just like the markets do, when it's bearish - you are searching for buyers). By the same token, when the the auction reaches higher prices, you are going to have continually less bidders, until you only have two bidders left (a reduction of volume). Eventually, you will have a single bidder left, and that's when the auction comes to a close - only in OUR auctions, it begins to auction the other way!
I was trading the ES today - we had a big spike in the morning, but prices were quickly rejected, and reverted back into the range. Even from the open, I could see that volume was not transacting very well at these levels. When we had that excess out of the open, I had tried to enter twice on the retracement, but all the volume that was being put out by the longs was absorbed, again and again. The fact that we put in that excess, but the POC did not move up (and we traded right back into the range) was a fairly bearish signal. Similar to the Value Area rule, any time you break outside of the prior day's value area, and then trade back into it, you have an 80% chance of trading all the way through (according to Jim Dalton).
ES then went on to chop around for the rest of the morning/afternoon. The swings became progressively smaller, from the morning spikes being 14.5pts, to the afternoon swings averaging around 4-8pts. Volume was also very low, and was receding across multiple instruments (ES, RTY, CL, GC). Volume always serves as a source of confirmation; think of it like an army, engaged in battle - if that army didn't have very many soldiers, tanks, ships etc... how easy would it be to defeat them in battle? Needless to say, this was the first, big, red flag for me.
Finally, near the end of the session, ES broke down with strength, trapping out everyone who got long in the range, and breaking below the low of the day.
Point being, we can utilize volume as a source of confirmation. If volume is not transacting well at the current levels, then prices may need to advertise higher or lower, in order to bring in new business. This is also why it's so important to do your homework, because if you didn't take the time to check the higher timeframe charts before you started trading, you wouldn't realize that volume was transacting so much lower than the average. Concurrently, had you looked at multiple symbols, you'd have noticed that momentum was waning across the board! Point being, always do your homework, and pay attention to volume. Again, price is the advertiser - volume is the confirmation. If you don't have both, then what you have is weak momentum - a precursor to any reversal.