Dissecting A Reversal Trade

On Monday 14/5/2012 I tweeted a trade to sell Bunds. I was greeted with sympathetic well wishes as the Bund was on a rampage to record highs. The trade was based on a simple custom indicator I use, the creatively named “Distance from 200 MA”. The idea is that when price moves a certain distance away from the 200MA then a reversal is likely. At the very least, the advance usually pauses. I produced the following chart.

After about half an hour where the trade was looking promising, the Bund went on to make one final push higher and the trade failed. I took my 10pt loss and moved on to the next chart/trade. Below describes what happened.

You’ve probably noticed that price did in fact retreat. Following that high, price moved down about 80pts after which my indicator produced a buy signal. I wasn’t at the screens at the time but the 200MA indicator made an overextended low matching previous lows. It was a definite buy signal, and it came about 2 1/2 hours prior to the news of new Greek elections.

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I use the above indicator on both 5min and 1hr charts. Naturally the signal is stronger when both timeframes produce it.  It’s not particularly new only that I haven’t put it out in public before. It’s a replacement for the MA envelopes that I used to use to gauge reversals. For simplicity I like to call it a rubber band trade (should I call it #RBT on twitter LOL). This kind of trade idea is nothing new and I’m sure it is known by many other terms.

It’s not a trade I like to share often as I know I’d get many cries of knife-catching and counter-trending and anti-momentum. That is true to an extent, but markets don’t move in a straight line and have to turn at some point. And it’s particularly true that in bear markets volatility is higher meaning both down and up moves are greater. So after a kerplunk/rally a nice reversal always usually follows, and it’s my intention to either a) close an existing position or b) cash in on the new direction.

As with any system, trades can and do fail so know your risk and limit your losses. On a knife-catching counter-trending anti-momentum trade such as this, it is especially imperative. 🙂

10c

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2 thoughts on “Dissecting A Reversal Trade

  1. hey 10c. really decent blog you have here.

    My thoughts on the indicator:
    i have played around with the exact same indicator before. Here are some of my findings:
    – if price is in a clear uptrend such as your first chart, only use the indicator when it exceeds a distance below the Long Term Moving average. I didnt like using it the way you applied it on the bund (chart 1) as i was not a fan of fighting the general trend (i found i was losing more pips from fighting it then following it with this approach).
    -also i found that turning the indicator into a line instead of histogram type chart, allowed me to place trend lines more clearly, to find potential probable turning points. (the trendlines acted identifcally to ones on price and further supported these lines).

    The ultimate decision i made was to drop this indicator. it didnt improve my trading and added more information to the equation…. which i did not want. it created competing signals with my primary style, and it made my trade plan more ambigous. i hope you have success with it.

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