Anatomy of a Reversal
A huge proportion of traders are focused on trading reversals. Usually, there is some method of setting levels at which a reversal may occur; Support & Resistance, value areas, volume profile, pivot points, Fibonacci are all commonly used methods of setting locations where a reversal may occur.
There is nothing inherently wrong with trading reversals, but it is worth considering WHY traders are attracted to reversal trading and what the downsides may be.
Why Trade a reversal?
Reversal trades are attractive for a number of reasons. If you trade a reversal, you stand to benefit from a larger move. A day trader may see a market moving down and attempt to buy the low of the day in the hope of selling at the high of that day. In that case, the whole daily range is the theoretical potential for that trade. The stop loss on a reversal trade is usually obvious and visual. It’s just the other side of the reversal level. So, it becomes an easy trade to handle visually. It seems like a more natural way to trade and manage those trades.
There are some downsides to trading reversals. First of all, the very nature of a reversal is that you are trading against momentum. It’s ‘easier’ for a market to carry on doing what it’s doing than it is for it to do something different. Not all reversals are equal in this respect. I like to consider reversals as major reversals and minor reversals.
Image 1 – Swing charts, major and minor reversals
In Image 1, we have a high at 4498.50, I consider that to be a major reversal, that’s the point at which the market rolled over, and that price became the high of the day session. The minor reversals are the pullbacks on the way down.
All reversals have the same three elements that cause the reversal to occur from a mechanical perspective. Before we look at those elements, let’s consider how a minor and a major reversal differ:
- A major reversal occurs when there is a major shift in trader behavior.
- A minor reversal occurs when counter-trend traders give up.
The minor reversal trade is still trading on the side of overall sentiment. The mechanical elements that make the reversal occur are the same in both cases, but the minor reversal is less of a shift in behavior. That makes them easier to read.
Major reversal areas tend to be fairly well known. In fact, if your method of setting a major reversal price is ‘secret’ then it most certainly won’t work. You need to create price decision points at which a large number of traders will change their behavior. If other traders don’t have that price as a target or an entry point for a reversal trade, then the price will not reverse. Of course, if the area is well known, then it is more prone to being ‘gamed’. More likely that predatory traders will come in and start nudging price around to try and shake you out of a position. Those predatory traders may not be able to prevent the market from reversing, but in certain market conditions, they can push the market against the reversal for long enough and far enough to take out the stops that they know reside on the other side of that level.
By their very nature, the major reversals are noisier. They cannot be expected to reverse as cleanly. There may be pushing and shoving. Minor reversals, on the other hand, are relatively tame. There’s not so much gaming going on, they require smaller stops and are clearer to read. Major reversal traders will suffer more frequent losses because the nature of their trading is that they are trading against overall momentum.
The Elements of a Reversal
Reversals are made up of just three elements. Or rather up to three elements as some reversals will occur with just one of these elements present. A market simply cannot reverse unless one or more of these elements are present. That applies to all markets, all reversals. This applies to both major and minor reversals, although for reasons stated already, the minor ones are easier to read.
Any trader that wants to significantly improve the performance of their reversal trading needs to know how to look for these elements. For the sake of simplicity, let’s consider a long to short reversal.
Element 1 – Absorption
The market is moving up and buyers are dominant. Absorption occurs when buying continues to be dominant (market orders) but price no longer moves up. Sell-side liquidity/limit orders are absorbing the buying. In some cases, the limit orders are visible as we move towards the level but quite often, more limit orders are added as buyers trade at that level. This is what is known as an iceberg order.
In terms of being easy to spot, this element is the easiest. Absorption takes place over a decent amount of time, on thicker markets it can take many minutes. What it means is that the sell-side is stepping up and absorbing all the buying – buying is no longer able to move the market up and eventually, the buyers give up or run out of money.
Image 2 – Iceberg Order absorbing buying – Jigsaw DOM/Time & Sales
Image 2 shows a typical iceberg order. In yellow box A, we can see:
- 1994 – Number of contracts traded (buy market orders buying from sell limit orders)
- 1081 – Number of limit orders
- 2848 – Number of limit orders added
So, we can see that since we have been trading at the level, the number of limit orders displayed on the DOM was kept as buyers continue to buy.
In yellow box B, we can see that some very large traders were buying 122’285, but price didn’t move up at all. Those traders are trapped.
In some cases, you will be able to join the offers, but this really depends on the market, most of the time you’ll have to step in front of the offers. I, personally, would like to see one of the other elements in addition to this when trading a major reversal. For a minor reversal, I am quite happy to trade this as confirmation.
Element 2 – Buyer Fade
The buyer fade occurs when we get to a price no one wants to buy anymore. Sometimes this is a gradual change. 1000 contracts trade, and we move up, then 600 trade, and we move up again, then 300 trade, and we move up once more, then 12 contracts trade, and we are done. Other times you have regular trading at all prices, then get to the next price and there’s just no one there. Ultra-thick markets like Treasuries may just hit this price once, but the ES tends to go to the level a couple of times – and each time either none or a really small number of contracts is traded.
This is fairly easy to spot but you often don’t have the luxury of time as you do with absorption. Be aware too that markets do pause, so you need to be looking for buyers fading at a key level. There is a time element to this, it takes time for the buyers to realize no one is buying anymore – then they will start to unwind, and you’ll see the sellers come in.
Confirmation with Order Flow helps to keep you out of bad trades – but not all confirmation is equal in terms of entry price. With the buyer fade, you want to give the buyers a chance to come back and hit the market, so you wouldn’t want to get in 3 seconds after you see a small number of contracts traded. The best entries are when we come back to that same price and print even fewer contracts. Other times, the market will start moving down more quickly. Bear in mind that confirmation does give you a higher hit rate, you have to be prepared to give up a few ticks to get that confirmation on some occasions.
Element 3 – Sellers Jump In
With this element, you get to a level where sellers start hitting aggressively with size. Many times this will be after absorption or a buyer fade, but other times it just comes out of the blue with no warning.
You will most likely see the volume of sell market orders be 2-3 times the volume of buy market orders when this happens. This is hard to spot in a timely manner. In other words, by the time you spot it, the market will have ticked down 2-3 ticks. At that point, you can decide to get in at a “worse price” – effectively trading a good price for certainty. That doesn’t make it a poorer trade.
Summary
This isn’t rocket science, just common sense. These elements are not mutually exclusive; we expect most reversals to be a combination of one or more elements. For instance, the absorption and buyer fade are often followed by sellers jumping in after a short pause. One or more elements will be present with any reversal. Now that you know what they are, you can look for them – either before OR after you enter a reversal trade. There is no law today that says you must confirm trades before entry. You could put a resting order to sell at resistance and then look for the 3 elements of a reversal. If you don’t see them, you exit the trade.
My personal preference is to look for these elements and not enter until I see something confirming.
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Order Flow itself is simply information. Just like charts, it can be used in a number of ways, some good and some bad. But let's first break down order flow into it's components so we all agree what we are talking about:
Order Executions/Tape Reading - This aspect is the real flow of orders. It's the information we see in Time & Sales, Footprint Charts, Cumulative Delta. It is looking at market orders, either as they execute or historically. I guess this is the "true order flow". Every trade is a buy and a sell. We look at market orders because we consider them to be more aggressive. When someone trades with a market orders, they are giving up a price to get an instant fill. Limit orders on the other hand just lazily sit there waiting for a market order to hit them. Often these are market makers with no directional conviction. So we see market orders as being more significant.
But we don't use these in isolation.
Volume Profile/Positions - The tape reading part helps us assess various things like momentum, traders getting stuck, balance of trade BUT the volume profile helps us understand where people are positioned and likely to get stopped out. I sometimes call this "Order Flew". It's important to know when trades will be "washed out" - for example - if we have a volume cluster on the S&P500 Futures and the market moves up 100 points and back down to it, it's unlikely short term traders on either side that were positioned there will still be there. But recent, nearby volume helps us assess areas of positions.
Market Depth - The bids and offers, the lazy passive orders waiting to be hit. This is part of the story but in terms of overall importance, I'd put it at around 20% at most. For example - if you return to the high of the day on any market, the offers will be quite large directly above the high. It means nothing at all. It's just a quirk of the market. It does not help you tell if a price will hold. On the other hand, if you see large depth and as we approach it, we see more added to the depth in front of that price, it means others are front running that depth and that is a useful bit of information.
This is the key - it is all just information. Just like price charts are information. When people look at Order Flow, they consider it to be a technique more than a set of information. They look for things like iceberg orders and decide to make a one rule trading system to fade every iceberg, For these people - yes, order flow trading is overrated because they are trying to ignore everything else going on in the markets and construct a trading system a chimp could execute.
For those looking to improve a decent trading approach, the best thing to focus on in Order Flow is momentum. Once you can read momentum you can:
- Avoid getting into positions when momentum is against you.
- Confirm trades are working after entry when momentum goes your way.
- Exit trades in profit when momentum fades.
That's perhaps the easiest way to use order flow because momentum is easier to read. It's about the market continuing to do what it's already doing. On the other hand, reading a turn in the market with order flow takes a higher level of skill and a little longer to learn.
Order flow can't put lipstick on a pig. It won't help you 'improve' something that doesn't work anyway, which is why whenever someone calls me, the first thing I ask is what they are currently doing and we discuss whether they need a reset or whether it will actually help.
When Jigsaw started back in 2011 - we were one of the first in the space and certainly had the best education. It was always going to attract the underbelly of the trading education/tools world and now we see stuff out there that is so complex but so impressive and futuristic that new traders are drawn to it like moths to a flame.
So here's my advice when looking at Order Flow
- Order Flow can't improve something that doesn't work.
- Order Flow can be used on it's own, without charts to enter and exit the market but you also have to be able to recognize different market states that need different/altered setups. There is nothing magical about this.
- Don't start jumping at shadows and take 50 trades an hour in your first week looking at Order Flow, be selective. It can be exciting to see cause and effect play out in front of you for the first time but don't overtrade.
- Do drills to learn how to read it before you trade it.
- Markets can only go up and down. Don't overcomplicate it. If you have too many Order Flow tools on your screen - you will not be able to make consistent decisions. Less is more.
- Take time to choose a market with a pace you like. Interest rates might send you to sleep, the DAX might give you a heart attack.
It is hard to see how a set of information could be overrated. It is true that some methods of presenting this information are better than others. It is also true that some people simply get on better with different tools (e.g. Footprint vs DOM).
There's a middle ground between complexity and simplicity that will leave you making consistent decisions where you improve over time. For those people, Order Flow will be way underrated because they will be the one's getting the most out of it.
Those that jump in with both feet on day one and those that have 100 different tools up, for those, it's a painful experience.
Keep it simple and manageable. Start with momentum reading and build from there. You will never look back.
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