Reversal Distances A Key Metric

When a price break chart reversal occurs, except for isolated instances of flip-flops, a new sequence of black or white boxes is set in motion. This happens, of course, because the countersentiment was usually strong enough to generate a reversal condition. Let's consider some important questions that arise in relationship to the reversal event:

V How strong is the reversal?

V Can the trader know?

V Does it matter?

These are important questions because if a trader knows how to derive some reliable answers, he will have the potential to generate very effective trading tactics.

In approaching an answer, it is useful to consider how we should evaluate what really occurs when a trend reverses. Using the example of a three-price break chart, a trend is considered to have reversed when the price has moved back three previous closed highs or three previous closed lows. This means that the sentiment has picked up energy and now is able to force a reversal. In other words, the price has driven through the previous thresholds. Therefore, it is likely to continue, because there is momentum behind it. New questions now arise: How far will it continue? What is the expected stopping distance?

We can derive the answers by counting the reversal sequences. It is unfortunate that platforms that offer price break charts do not offer analytics on price break patterns.

However, here is how to do your own reversal distance analysis for price break charts:

1. Generate the time series of the prices.

2. Locate the first reversal block (in either direction).

3. Measure the low and the high of that block.

4. Count the number of consecutive blocks (black or white) that appeared when a reversal occurred.

5. Repeat the process for every sequence of lows and highs.

To use price break charts effectively in a scalp-style trade, the trader should first determine the average stopping distance following a price reversal. Once he knows that average, the trader can shape several trading strategies based on the average. If it is almost always the case that a reversal occurrence results in a series of new highs or new lows, then trading that phenomenon with a scalping strategy is worthwhile to pursue. Each market traded has its own reversal signature, and in each case, data on reversal distances needs to be generated and evaluated. What are important are the maximum and the average reversal distances. Once the trader knows these two fields of data, he will have the ability to preset scalping entry and exit targets. We will show this in Chapter 8.

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