The Reversal System—Hedging versus Speculative Trading Strategies

One of the purposes of our service is to demonstrate how to develop your own trading techniques using the numbers provided on the daily and weekly reports. The recommendations provided in our reports are NOT the most aggressive strategies one can employ using the Reversals. Furthermore, the use of the Reversal System for hedging or aggressive speculation is totally different from conservative speculation.

As stated previously, the Reversal System maps out a market into areas of key support and resistance. For example, if we look at the 1987 high in the S&P 500, the Reversal System had mapped out the key levels to watch. The Daily Bearish Reversals were clustered between 330 and 318. Then the Major Weekly Bearish Reversals lay at 303 and a Double Reversal at 28610. There were no other Reversals to be found on the Daily or Weekly levels after 28610. The next key Reversal Point was 18100 on the Monthly Reversal System.

The Reversal System defined two gap areas: 318-303 and 286-181. Electing all the Daily Bearish Reversals brought us to the beginning of this first gap at 318-303. Since there was nothing within that price area, it was logical to assume that eventually the market will gravitate down to fill that gap and find support, which would then start again at 303. The S&P 500 worked its way through that area and continued downward penetrating 286, where another gap was encountered. This signaled a move to the 181 level which, in fact, occurred with the October ’87 low forming at 18130.

This is a classic example of the “mapping” of key target areas within a market regardless of how chaotic the price activity becomes. When we are dealing with minor highs and lows, the same mapping procedure applies but the gaps are more orderly and less dramatic.

To easily visualize the methodology, let us set up a series of theoretical Bearish Reversals in gold as follows: 482, 454, 425, 398, 376, 342, 336, 320, 303, 280, 192. Also, let us assume that gold is currently trading at 487. One strategy would be to sell on the execution of each Reversal and cover on the next. This would be used for more aggressive speculators and hedgers. Those looking for a more conservative approach would sell upon execution of the Bearish Reversals and cover only when the subsequent Bullish Reversal generated from the new lows is elected.

First, we will examine strategies for entering the market. For example, if 482 were a Daily Bearish Reversal, then two possible orders can be implemented to establish a position in the market.

Entry Strategies

• Strategy #1: Use a “Sell Stop Close Only” at 481.50. It is usually advisable to use a limit-perhaps $5 in gold or 100-150 points in the S&P depending upon volatility.
• Strategy #2: Use an “Intraday Sell Stop” at 480.90 with a “Protective Buy Stop Close Only” at 482.50. In addition, an “Intraday Protective Buy Stop” should be placed above the next whole number or previous week’s high, whichever is lower. If the previous week’s high was 494 then use the whole number 490 placing the stop at 490.60.

Strategy 1 has inherent risks associated with it. During extreme volatility, the order may not be elected as the market could close sharply lower beyond the limit. Strategy 2 will handle an extremely volatile period very well by getting you into a short position close to the key target area. But during quiet periods, a market could slightly penetrate the Reversal intraday and still close above it at the end of the day, thus avoiding execution. This poses some limited risks of loss when intraday penetration proves to be only a false move.

The above examples are the two primary methods of using the Reversal System for entering a market. They are simple to implement in most markets. However, in some markets you may find a broker who refuses to take “Stop Close Only” orders, particularly on the Chicago Board of Trade which does not recognize this type of order. We suggest that you work out a solution to this with your broker.

The exit strategy is most important. Often, traders find that entering the market is easy; when to get out offers the real problem. Many inexperienced traders will allow a profitable trade to run very short-term while allowing their losing trades to run until the pain becomes too great. This is typical for beginning traders because one of the most difficult things for many is to admit that they are wrong. One good rule of thumb is to cut losses quickly and allow profitable trades to run until it starts to move more than 1.5% against you from the highest profit point. This guideline works well in normal markets but it will be much less effective during panic situations such as the Panic of ’87. In the case of panic, only our forecasting methods and the Reversal system will survive. If you waited for a 1.5% move up from the low, your fill might have been 25% or more away from the low. Panics are not known for providing good fills or orderly trades. Exiting strategies are the most important because they involve much more emotion to overcome than entry positions. Upon entry, confidence is usually high but upon exits, confidence can be the last thing on your mind.

Exit Strategies

• Strategy #1: Cover the position on the next Reversal using an MIT (Market If Touched Order). For example, if you are short from the 482 level and the next Bearish Reversal is 454, use an MIT at 455 or 456 to buy back the short position. Reenter the market using the entry strategy most appropriate (entry strategy 1 or 2) with the 454 Reversal. Continue this strategy from Reversal to Reversal until the market stops.
• Strategy #2: Each new low produces a Bullish Reversal. Likewise, each new high produces a corresponding Bearish Reversal. Exit the market if the corresponding Reversal is executed. For example, if a short was taken near the 482 level and the market drops to the 458 area, a Protective Buy Stop Close Only must be placed slightly above the Bullish Reversal generated from the new low at 458. Let us assume this Reversal was 463. Two strategies would then be possible.
• Strategy #2a: Use 463.50 “Protective Buy Stop Close Only.” This is recommended for normal volatility.
• Strategy #2b: Use either the next whole number or previous week’s high as long as they are above 463. Place an “Intraday Protective Buy Stop” at 470.60 on the whole number basis. Also use the “Protective Buy Stop Close Only” at 463.50 on an OCO basis (One Cancels the Other). OCO is IMPORTANT! Otherwise, you could be stopped out of the short position intraday and find yourself long at the end of the day. In addition, if the intraday buy stop is elected, you must then enter a “Sell Stop Close Only” at 462.50. This would reinstitute the short position if the move to the upside proves to be false at the end of the day. The big risk is getting whipped in and out of the market. Potentially, if volatility is very high, you could create a losing day trade being stopped out at the 470 area and back in at 462. On the other hand, if the market is truly reversing trend, then being stopped out at 470 when the market closes at 480 would be viewed as a blessing. This added protection during highly volatile periods is worth it when forecasts for a major turning point exist.

Because election of a Reversal is only on the close, it is necessary to enter orders a little beyond the Reversal number in order to minimize the possibility of the order being elected improperly as part of the closing range (instead of the official close). Most futures contracts have a closing period of one to several minutes during which time all prices are considered to be part of the closing range. From this activity, the closing price is determined. For example, Comex Gold may close in a range of 365.10 to 365.50 and settle at 365.30. If the Reversal number was 365.40, the election would not have occurred even though the Reversal number was traded at as part of the closing range. For this reason, we use the following additional tics to the Reversal numbers for orders:

The Reversal System has worked better than any other system we have seen for defining the gaps within a market. Most of the time when one level is penetrated the market price activity will continue to the next available Reversal. Normal markets have Reversals evenly dispersed above and below the current price activity. It is when large gaps exist between levels that we find greater potential for panic. Simply put: when Reversals are evenly dispersed, there are a greater number of support and resistance levels to penetrate. This requires more energy within the system to create a panic situation. But when Reversals are clustered together in particular areas leaving gaps between them, then price movement can become much more abrupt.

These are the main strategies which work well with the Reversals for both conservative and aggressive speculation or hedging. Stepping in and out at each Reversal as it is approached seems logical and easy to implement. However, keep in mind that this Reversal System works best under extreme volatility rather than the opposite. The greater the panic the higher the accuracy. That means that some of the best calls take experience, confidence, and above all courage. When this system has been infallible, it has always come at the peak in emotional stress. During extremely narrow sideways congested patterns, it is best to avoid the Reversals generated from every minor temporary high and low with the trading range and focus on the intermediate Reversals.