In today’s option trading blog I will discuss trading reversals. People associate reversal trading with picking tops and bottoms. It is chic to be a contrarian and the masses are always wrong – right? That is certainly not my perspective. TASR was over valued at $30, $70, $90 and $110. All along the way you could have convinced yourself to short the stock and play the reversal. Stocks can stay over bought or over sold for long periods of time before they reverse. In the referenced example, the early shorts never got to see their glory – they were carried out in body bags.

Here’s how I treat reversals. There are two different types and they are each treated differently. For illustrative purposes I will use bullish examples for both.

The first and most common of my reversals identifies a strong long-term up trend and a pull back to support. The support can be a moving average, a trend line or a horizontal support level. When the stock tests this point and finds support I have a reversal candidate. I’m not looking to go short the stock, I’m looking for a good entry point to get long a strong stock. I classify it as a reversal because the stock is ready to reverse the “dip” and get back on its long term trend. The trend is your friend and you should always have the wind at your back. For this trade to work, you have to make sure that the pullback in price was temporary. It could have been the result of a market decline or perhaps the stock just got ahead of itself. In either case, look at the news and make that determination. The energy stocks were a great recent example. Nothing changed fundamentally and oil prices stayed high. The sector was too hot and some of the “air” had to be let out.

The second type of reversal follows a more conventional definition. For bullish reversals, I look for stocks that have been in a long term down trend that has stalled. I want to see a solid base that has formed over the course of a few months. In this instance I use horizontal support. It tells me that at a specific price, there are buyers. I want to see signs that the stock is ready to move higher. I look for the stock to be stable when the market is down, I want to see the stock pop when the market is up (relative strength). I also want to see increased volume on up days. Finally, I need to know that the company is fundamentally strong and that the issues have been resolved. These trades tend to be longer-term in nature and they require a bit of patience. The key is to make sure that a move off of support is under way and that the stock has broken through at least a minor resistance level. A good example would be LXK when it formed support at $45 for months and broke through $50 on good volume. A bad example would be MFLX. It did not spend enough time forming a base at $26. Yes, I got caught on this one.

Personally, I prefer the first group of reversal trades. They work particularly well in bullish markets and longer-term momentum will help the reversal materialize. I often use the second group of reversals during market sell offs. These stocks have already been beaten down and they represent a good fundamental value. I also know that strong support is nearby. The key to trading reversals is to make sure the prior move has exhausted itself. Going against the grain while a move is still intact is suicide.

Share one of your reversal trades and I’ll comment.

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