By Sashi Asakura

Do you trade reversals with something like these rules and conditions?

Sell when a price hits an upper Bollinger band and RSI is overbought

Buy when a price hits a lower Bollinger band and RSI is oversold

Sell or buy at MACD crossover and MA crossover coincide

I know I know most of these reversal conditions are from the internet and basic Forex books that are just explaining the basic definitions of technical analysis tools….but there’s a tiny little problem.

We look at the market from pure price standpoint using bollinger bands and RSI and MACD and MA, but we are ignoring volume momentum analysis. The market leaves three distinct traces to us at any given time: price, volume, and time. And if we don’t use volume information, we are basically looking a flower on a black and white TV losing all the colourful information like traders’ emotions, sentiments, and momentum.

I hate to say this but that’s exactly how most Forex traders trade because nobody really talks and teaches the importance of volume momentum analysis. All they care about are shapes, lines, and cool looking colourful indicators..

So if you have done that in the past, it is time to wipe that blemish away from your career canvas and start afresh.

Let’s start with the mindset..

The Mindset:

Price represents consensus of value, while volume represents emotions of participants – intensity of traders financial/emotional commitment as well as pain of losers

Price reflects rationals while volume reflects their commitment, feeling, emotion. Crowd is more likely to follow its heart and emotion than its mind and that’s why volume often precedes price.

The Philosophy of Trend Reversals

Let me explain how trend reversals happen:

When price is going up, there are two things happening in the market:

1. sellers are getting stop out because price is going up. Sellers exit the market by closing their sell positions by buying, which causes the price to go up more and their lost money gets transferred to buyers profits
2. buyers are placing new buy positions because they feel more confident seeing the price hiking up. New buy positions push up the price even more.

However, eventually the market will run out of losing traders (sellers) as the price goes up, because most of sellers were already stopped out. So there isn’t much funds transferred from losing sellers getting stop out to buyers, so the price wouldn’t go up much more. There will be less new buy positions because less sellers getting stopped out and closing their sell positions by buying at stop out, so less price hike and less new buy positions entered by confident buyers. Eventually trading volume will decrease even if the price is close to the high.

This is when reversal is about to happen at higher highs because there is less volume of trades to back up price movements upward. It’s like an army led by officers in front of solders has strong momentum – but an army without officers and leaders at the front is likely to reverse. Same, trend without volume (officers) will likely to reverse.

Falling volume shows running out of supply of losers and trend reversal – old loser trades bailed out but few new losers come in.

It is to be on top of volume analysis to identify good reversals

That’s all. And this alone can make a difference between a great reversal trade materializing into profits or your trades getting burned immediately by fakeouts right after the entries.

So, how do your remain top of trades?

The Foolproof Formula of Reversal Spotting

Two very quick and extremely effective formulas that I have used countless times are below:

1. Use “Traders Dynamics Index” (TDI) indicator

TDI is like RSI, Stochastics, and Moving Average all combined plus on steroid. RSI and Stochastics often give you overbought and oversold signals when trending, and don’t give us much about when it’s likely to reverse. Whereas TDI, it uses moving average of RSI to identify reversals, and TDI crossover is proven to be way more accurate than RSI’s oversold/overbought signals.

2. Use “Average Directional Index” (ADX) indicator

ADX takes into consideration momentum. If ADX value is < 40, then the market is quiet and not trending, like officers front of solders are retreating and thus losing momentum. Also, if ADX+ and ADX- line crosses over, then the marker reverses its trend.

Let me show you what I mean:

See that wasn’t complicated or mumbo jumbo.

Stop trading like this because I don’t have any idea what is going on.

Make sure to look at the market from right angles. If you are using price and candlestick patterns and lines only, you are discrediting the important market sentiments (volume information) and are losing a third of the market information right away.

About the author:

Sashi Asakura is the founder of www.IntrovertedForexEngineer.com, the only place on the internet that makes Forex trading classy, systematic, and scientific. As a full-time software engineer and 6-year Forex trader, he develops effective algorithmic Forex systems backed by statistics and methodical testing.