Successful trading isn’t about big egos and swinging for the fences.
I’ve been trading the markets for over 40 years – including a 20-year winning streak during my hedge fund days.
And I can tell you that successful trading has a simple recipe.
The ingredients are risk management and developing an edge.
Risk management means position sizing properly and not risking more than you can afford to lose. Risk management is how you stay in the game.
Developing an edge for spotting trading opportunities is the tougher part.
Successful traders are obsessive about developing their edge. They stick to a formula that works… instead of jumping from one strategy to another.
Today, I want to pull back the curtain on an edge that’s served me well…
Defining Your Edge
Most experienced traders fall under one of two categories when it comes to developing their edge: trend following or mean-reversion.
Trend following is exactly what it sounds like. Traders attempt to spot a price trend and get in as soon as possible.
Think of it like a surfer catching a wave.
Trend followers try to catch the wave as it starts emerging and ride that wave for as long as possible.
On the other side, mean reversion looks for a price trend that has gone too far in one direction and is ready to reverse course.
A mean-reversion trader wants to profit as the wave starts to crest and roll over.
A sudden change in direction is the profit opportunity.
Most of my trades fall under the mean-reversion category. Knowing when a trend is about to reverse course has served me well.
And let’s look an example of a reversal pattern that keeps showing up in a key market…
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The Dollar’s Repeating Reversal Pattern
Strong reversal patterns emerge when a key price level is being tested while momentum starts diverging at the same time.
A key price level could be support or resistance. Support is a level that has seen buyers step in. Resistance is a level where selling pressure shows up.
We can measure price momentum with technical indicators. One of my favorites is the Relative Strength Index (RSI).
So here’s how to combine key price levels with the RSI to spot potential reversals.
The U.S. Dollar Index (DXY) has traded in a range going all the way back to the start of 2023. That range provides us with key support and resistance levels to watch.
That’s shown with the two shaded areas on the chart below.
When DXY is testing those levels, start watching for signals from the RSI.
A “momentum divergence” develops when the RSI stops confirming a price trend. In other words, notice when the price is moving up but the RSI is falling – and vice versa.
Take another look at the DXY chart:
Points A and B on the chart show tests of resistance at the high end of the range. During those tests, the RSI made a negative divergence with a lower high (see first and third dashed lines).
Points C and D on the chart show tests of support at the low end of the range. In those tests, the RSI made a positive divergence by making a higher low (see second and fourth dashed lines).
In each instance when DXY has tested the extremes of its trading range alongside an RSI divergence, a reversal has occurred.
That’s an example of a mean-reversion tactic in action.
There’s no guarantee that this pattern will deliver a major reversal all the time.
But a strategic edge like this is one way to find trading success over the long run.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict