Price reversals are one of the many ways to trade in the market. Candlestick patterns are a simple and robust way to set up reversal trades. This week, we discuss the steps to set up reversal trades using derivatives.
Bear power
We first discuss bearish reversal strategies. Note that bearish reversals do not always mean that the stock is on a significant downtrend after an uptrend. These strategies include uptrends that are halted with bears likely to be temporarily in control of prices. The following are the steps you could adopt to set up bearish reversal trades:
Firstly, identify bearish reversal patterns on stocks that have been a continual uptrend. If you observe that the underlying has printed seven or more consecutive green colour candles recently, the more likely a reversal could happen. Typical bearish reversal candlestick patterns after a continual uptrend could be a bearish harami, an evening star, bearish engulfing or a dark cloud cover.
Secondly, an aggressive entry involves setting up an appropriate position the next day when the underlying trades below the low of the previous green colour candle. That is, if the price forms a harami on Wednesday, you must use Tuesday’s low for Thursday’s intraday entry price. A more conservative entry will be on Friday if the price on Thursday closes below Tuesday’s low. You could set up either short futures position, a long put or a short call position depending on your risk appetite. Note that futures can provide a one-to-one movement in the underlying whereas long put cannot. The option premium should be the maximum gain on a short call position.
Thirdly, your stop-loss ought to be the (underlying’s) high of Tuesday’s candle if you set up short call or long put position. If you were to set up a short futures position, your stop-loss must be the high of Tuesday’s candle on the futures chart.
Fourthly, your price target can be based on absolute gains (say, 10,000). Then, you must divide this number by the permitted lot size and add it to the entry price to arrive at your price target. Alternatively, you could use a Fibonacci retracement on the recent up-move. Your price target could be 38.2 per cent retracement level. Whatever rule you apply for your price target, you must be mindful of the nearest support level. If the support level is higher than your price target, the support level must be considered the first price target.
Optional Reading
Setting up a bear put spread takes advantage of your additional view that the underlying will take support at a certain level. You could then short the strike immediately lower than the support level. This would lower loss from time decay but increase your cash outlay because of margins on the short strike. As for the short call or the short futures position, you can protect your upside risk by going long on an OTM call, one strike above the resistance level.
(The author offers training programmes for individuals to manage their personal investments)