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Reversals and Fake-Outs

So the market is at the high of the day, and it's approaching a key resistance level that you anticipate a possible reversal. Volume has been slowing waning, and the bar/swing length has been getting progressively smaller. Everything is pointing to a possible breakdown. The tempo slows down immensely, and the market starts to turn, and then a large sell order comes in, setting up your reversal bar, and you enter the trade.

Everything seems to be going swimmingly at first. You are watching price get further and further from your entry price on the DOM. The market approaches VWAP, and then it just stops. It hovers for a minute, a few ticks up, a few ticks down, a few ticks up, a few ticks down, a few ticks up... and then it starts to backtrack.

You don't panic at first, as it's just a pullback - right? It gets one or two bars of movement in, starts to turn again, and then you add to your reversal. However, your bar begins to wick; the bulls push it back up to where it closes on it's opening price (doji), and then following bar keeps pushing higher. The bears throw out a large order, and the bulls push it right back up again, so you move your stop a bit. Again, a large sell order, and then bulls push it back up again. By now, you're starting to panic. You are getting deep underwater, and it's approaching a 100% retracement. You're sweating bullets. The market gets to it's zenith, sloooowly starts to turn, and then a rapid breakdown ensues.

This is exactly what happened to me last night. There's an important principle that you want to employ, any time you are hoping to fade an extended trend. For one, we should only be taking reversal trades at areas in which you expect a major reversal. Secondly, markets do not go from bull, to bear - they go from bull, to balance, to bear. Point being, anytime you are taking a reversal trade, you are putting yourself in jeopardy if you are not allowing for a re-test of the high, before the major reversal ensues. Often enough, you will get a market that is stalling at the high, and it will be followed by a strong, flush lower.

We might assume that this is because all of the laggard longs had their stop losses very near the high, so when the market fails to break through resistance, those late-longs are flushed out. However, all of the longs that got in either at the very beginning, or midway through the trend, are still in good shape. They don't mind pushing the market back up to the high, to get out at better prices, because their average entry price will still be favorable.

Mack from PATS Trading always states that you never want to take a reversal trade unless it's had a re-test, and I couldn't agree more. Big players (higher timeframe) are much more likely to hold a position longer, and they significantly longer to get out of their position (because if they sold everything at the market, the market would immediately dump, and they wouldn't be able to get the prices they want).

Think of it this way: if you have a 10,000 lot position near the high of the day, would you sell it all at once? Hell no! If you sell 10,000 lots, the market is going to rip downward, losing (in conjunction with all the stop losses that would be triggered) probably 5-7 points right off the bat. Therefore, it may make sense to absorb some additional orders, push it back up to the high one more time, and then sell 100 lots at a time INTO anyone else still trying to shoot for a breakout; you might even drive prices THROUGH the high momentarily, triggering the buy-stops of all those who shorted at the high, to whom you can sell your shares/contracts (and anyone else hoping to jump on board the breakout). Key areas like the high and low of the day, particularly if they engage the higher timeframes, are much more likely to be "gamed."

Take note, that on rare occasion, you will get V-Top's and V-Bottoms, but they are the exception to the rule. V-Tops and Bottoms will often follow markets that have weak structure, such as the one illustrated below. This one-timeframing up as essentially one giant low-volume node (and we all know that low-volume nodes are price rejection areas, and therefore the market is likely to rip through it to the last area of value).

In any event, just be careful when you are trading reversals. Again, you ideally want to wait for a re-test on lower volume. If you enter into the initial flush down, and you aren't prepared to put your stop above the last pivot high, you are likely to be trapped. Furthermore, if it's a weak high (meaning it's already been probed into several times), and you have an unfinished auction above you, then the odds are even less in your favor. Point being, your strategy should depend on context, as weak structure is more likely to ensue a V-Top or V-Bottom, but if price has been grinding higher, and the POC has been increasing with price, then it's likely that the initial drop will be a fake out, and you'll want to wait for a re-test.

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