As you
learned earlier, when a trend moves for an extended period of time and it
starts to consolidate, one of two things could happen:
1. The price
could continue in the same direction (continuation breakout)
2. The price
could reverse in the opposite direction (reversal breakout)
Wouldn't
it be nice if there was a way to know to confirm a breakout? If only there was
a way to avoid fake outs...
Hmmm...
You
guessed it.... THERE IS A WAY!
In fact,
there are a couple of ways to tell whether or not a trend seems to be nearing
its demise and a reversal breakout is in order.
Moving Average Convergence/Divergence (MACD)
By now you should have a good foundation of the MACD indicator. If you don't, you might want to check out our lesson on
MACD.
MACD is
one of the most common indicators used by traders and for good reason. It is
simple yet dependable and can help you find momentum, and in this case, the
lack of momentum!
MACD can
be displayed in several ways but one of the "sexiest" ways is to look
at it as a histogram. What this histogram does is actually show the difference
between the slow and fast MACD line. When the histogram gets bigger, it means
momentum is getting stronger. When the histogram gets smaller, it means
momentum is getting weaker.
So how
can we use this when trying to spot a trend reversal? Glad you asked!
Remember
that trading signal we talked about earlier called divergences and how it occurs
when the price and indicators move in the opposite direction? Since MACD shows
us momentum it would make sense that momentum would increase as the market
makes a trend. However, if MACD begins to decrease even when the trend is
continuing, you can deduce that momentum is decreasing and this trend could be
close to an end.
You can
see from the picture that as price was moving higher, MACD was getting smaller.
This meant that even as the price was still trending, momentum was beginning to
fade out. From this information, we can conclude that a trend reversal is
highly likely.
Relative Strength Index (RSI)
RSI is another momentum indicator that is useful for confirming
reversal breakouts. Basically this indicator tells us the changes between
higher and lower closing prices for a given period of time. We won't go into
too much detail about it but if you would like to know more check out our
lesson on RSI.
RSI can be used in a similar way to MACD in that it also produces divergences. By spotting these divergences, you can find possible trend reversals.
However,
RSI is also good for seeing how long a trend has been overbought of oversold. A
common indication of whether a market is overbought is if the RSI is above 70.
On the flipside, a common indication of whether a market is oversold is if the
RSI is below 30.
Because
trends are movements in the same direction for an extended period of time, you
will often see RSI move into overbought/oversold territory, depending on the
direction of the trend.
If a
trend has produced oversold or overbought readings for an extended period of
time and begins to move back within the range of the RSI, it is a good
indication that the trend may be reversing.
In the
same example as before, the RSI showed that the market was overbought for a
billion days (ok not that long). Once RSI moved back below 70, it was good
indication that the trend was about to reverse.
