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More than any other category, precise terminology is important here. If we were less
careful, we might apply a label like “trend reversal” to most of the trades in this category,
but this is counterproductive because it fails to precisely define the trader’s expectations.
If you think you are trading trend reversal trades, then you expect that a winning trade
should roll over into a trend in the opposite direction. This is a true trend reversal, and
these spots offer exceptional reward/risk profiles and near-perfect trade location. How
many traders would like to sell the high tick or buy the very low at a reversal? However,
true trend reversals are rare, and it is much more common to sell somewhere near the
high and to then see the market stop trending. Be clear on this: This is a win for a trend
termination trade—the trend stopped. Anything else is a bonus, so it is important to
adjust your expectations accordingly.
The obvious spots in the cycle for trend termination trades are where the uptrend
stops and moves into distribution, and vice versa on the downside, but there are other
possibilities. Some traders specialize in finding overextended spots in established trends,
and fading (going against the trend) these for a very quick and short reversal. For instance,
a trader might find spots where the rallies in the uptrend have run up too far too
fast, and take short positions against those rallies, planning to cover one to three bars
later. These are trades for only the fastest and most nimble traders; developing traders
are well advised to avoid these countertrend scalps because they remove focus from the
big picture. Staying in a consistent time frame is important for these definitions; a trader
might look for spots where the short-term downtrends (pullbacks) in the uptrend have
overextended themselves, and then take long positions against those lower time frame
downtrends. In this case, the trader is actually positioning countertrend on the lower
time frame but with the trend on the trading time frame. Is this a trend continuation or
trend termination trade? The answer depends on your perspective and your time frame,
and it is only important to be consistent. Understand what you are trying to accomplish
with the trade and how this best fits in the evolving market structure.
Trend termination plays are not usually high-probability plays, but the compensation
is that winning trades tend to offer potential rewards much larger than the initial risk. If
your patterns allow you to position short near the absolute high point of a trend leg with
some degree of confidence, then you have a well-defined risk point and the potential for
outsized profits on some subset of these trades. Over a large enough sample size, the
risk/reward profile may be very good, leading to a solid positive expectancy even if most
of these trades are losers.
Trend termination trades are countertrend (counter to the existing trend) trades, and
trade management is an important issue. Most really dramatic trading losses, the kind
that blow traders out of the water (and that don’t involve options) come from traders
fading trends and adding to those positions as the trend continues to move against them.
If this is one of the situations where the trend turns into a manic, parabolic blow-off,
there is a real possibility for a career-ending loss on a single trade. For swing traders,
there will sometimes be dramatic gaps against positions held countertrend overnight,
so this needs to be considered in the risk management and position sizing scheme. More
than any other category of trade, iron discipline is required to trade these with any degree