Is it a retracement or trend reversal? If we knew the answer to that question unequivocally, we would be sitting on a beach in Tahiti. Instead, you have the next best thing: My take on what constitutes a retracement verses a trend reversal and why clarity on this is crucial, advises Hugh Grossman, founder of DayTradeSPY.
As our staple, we trade options on the SPDR S&P 500 ETF (SPY). This ETF follows the top 500 US stocks, is highly liquid, sports tight bid/ask spreads, and has predictable behavior. It is also fairly easy to learn its nuances, requiring mostly emotional control to achieve financial success.
Price interpretation is vital for entry points. For example, if you are considering a put position, your ideal entry would be on a retracement, where the price pops back up to a resistance level, then rolls back down again. This would facilitate taking advantage of a downward trend.
On the other hand, if you enter a put when the price trend is reversing back up, you may have to brace for a challenging trade. It would be most comforting to know, as best as possible, if it is a retracement for an ideal put setup or a change in directional trend, whereby you may opt to look at call options instead.
To differentiate between a retracement and a trend reversal, I install my key indicators, those being the 10 and 20 exponential moving averages (EMA) on all my time frames. I also label my support and resistance levels along with pivot points on the five-minute chart.
The more these indicators intersect, the stronger the support and resistance will be. It only makes sense as some traders look at the 10 EMA, others the 20 EMA. Still others will follow support and resistance levels, including strike prices and pivot points.
The more these indicators converge at a particular price point, the stronger the support or resistance will be. However, as the price breaks through these converging levels on the one-minute chart, I consider that to be a change in the trend, at least in the short term. If the five-minute chart confirms it, I enter the new direction, usually looking to scalp a trade. A short-term gain is easier to achieve than aiming high.
I like to monitor the five-minute chart to reduce the “noise” but enter on the one-minute chart. For example, when the five-minute chart shows the 10 EMA over the 20 EMA, and both heading up, I wait until the one-minute chart pulls back and bounces off the 10 and/or 20 EMA, then enter when it turns green again. This, assuming there is ample room to move up before hitting the next key level of resistance.
