Any trader wants the perfect timing for any market, especially for catching magic reversal days-the points in time when the market changes direction sharply from a downtrend to an uptrend or vice versa. It is the siren song of driving home the precise bottom or top of a move, but just how realistic is it to reasonably capture those reversals? That’s because, by anecdotes and much of what you find on social media, there are huge moves when “something breaks,” but in reality, it’s hard to spot market reversals and, particularly, to make them profitably.
In this video, we’ll be backtesting two reversal day strategies; one bullish, one bearish on Gold (GLD). We will clearly define and test the trading rules for a number of technical indicators-including Relative Strength Index (RSI)-as well as other specific kinds of price action patterns that can form reversal days. We should backtest to show the existence of reversal days and if such strategies make sense.
We will see just how realistic it really is to catch reversal days on the market using well-defined trading rules with systematic backtesting. At the end of this video, you will know not only how to spot a potential reversal signal but also get data-driven insights into the performance of such strategies on much larger time frames. Let’s now dive into both bull and bear reversal day strategies and walk through their efficiency.
What Are Reversal Days and Why Do They Matter?
A reversal day is a trading day on which the market has a sharp directional change, that is, from a downtrend to an uptrend (bullish reversal) or an uptrend to a downtrend (bearish reversal). By nature, such days are also often related to specific price action patterns, like a strong move against the prevailing trend and, therefore, represent great trading opportunities.
Reversal days can be one of the best opportunities presented to trade some major market shifts that could bring in potential money for traders. However, all of them pertain uncertainty towards the pattern and timing, so trading reversals might be too tricky. But a few strategies, coupled with a few tools, can be used in order to maximize chances of trading a profitable reversal.
Bullish Reversal Day Strategy: Capturing Market Reversals
A bullish reversal day is the day where the market trends down but is yielding warning signs that it might be reversing up. Now, let’s talk about the rules for this system:
Bullish Reversal Day Trading Rules:
- Today’s Low is lower than yesterday’s Low: Which means that the market continues to trend down in the early action of the day.
- **Close Higher Today Than Close Yesterday: This should close on the higher note than the previous day, showing the rebounding indication.
- This 5-day RSI should be below 35. Relative Strength Index shows the magnitude of the movements in the price and below any time it becomes over-sold that the market is due for a bounce.
Testing The Bullish Reversal Day Strategy
Using the rules above on Gold (GLD), we ran the Optimizer function on our platform and studied the date of exit after 1, 2, up to 25 trading days. Here is what we got:
The highest average profit per trade came at the date of exit after 24 trading days at an average return of 2.02%.
- Profit Factor: The profit factor at the exit for all signals is high, meaning that this strategy is strong in regard to a bullish reversal.
- Trading Frequency: Although the strategy holds a lesser number of trades, the positive profit factor indicates that when this pattern gets activated, the market generally gives good results.
A bearish reversal day would be the scenario that finds the market having had a trend upward but reversing lower. The trading rule to follow in the applicable rules is,
Bearish Reversal Day Trading Rules:
- Today’s High is higher than yesterday’s High: The market is still up and making a new high.
- Day-Day Loss – End Lower Than Yesterday’s Close: This is considered a down day or a reversal where the market ends lower than the close of yesterday, hence proving to have some bearish momentum.
- 5-Day RSI Should Be Above 65: The RSI is too high at more than 65. Markets that are so high are rather due for correction, hence.
We tested the bearish reversal day strategy on the Gold (GLD) with exit points at 1 to 25 trading days. Results follow:
Highest Average Gain per Trade: The highest average per trade was 1.16% after 24 days.
Profit Factor: The profit factor was still in the blacks but was lower compared with that of the bullish reversal strategy, showing that the strategy did not quite do justice in picking up all the bearish moves.
- Performance Comparison : The bearish reversal strategy made some money, but to a smaller extent compared with that of the bullish reversal strategy.
Why the Bullish Reversal Strategy Performs Better
The Gold market (GLD) is somehow biased toward the long term to go up. That is to say that on average all time the price goes up. The consequence is that bullish reversal days tend to appear more frequently and more profitably in such a market. It is harder to catch bearish reversals for Gold is not so enthusiastic about holding on to the downtrends. That is, the long-term positive skewness makes it slightly more tricky to trade in bearish reversals by Gold since the price movement all seems to favor the upside.
Key Take-Aways from Our Backtest
- Thrashing the bull reversal strategy: Our backtest showed that the bullish reversal day strategy performed better on Gold, as it made a profit of an average 2.02% in every single trade since the system exits after 24 days.
- Bearish Reversal Strategy Was Not As Successful: The bearish reversal day strategy was also successful; however, it generated considerably much lower profits, likely due to a long-term upward trend of Gold. Moreover, it has a lower profit factor; therefore, it is less likely in the long run.
- RSI was extremely sensitive: Using the 5-day RSI, oversold conditions would tend to reveal the possibility of a bullish reversal, whereas overbought conditions for bearish reversals. That means that most of the entry signals would be pretty reliable.
- Realistic Expectations: Ideally every trader dreams to catch the perfect reversal points, for which we need to be setting realistic expectations. Generally speaking, bullish reversals are much easier to catch in uptrending markets, while bearish reversions call for much higher caution, specially in uptrending markets.
The last section of this article discusses reversal day strategies and their nature as bullish or bearish; these are really interesting strategies for traders to take advantage of specific turning points in the market. However, our backtest results reveal that the bullish reversal day strategy works a little better than the counter-party and can be applied simply obviously in markets such as Gold that exhibit long-term upward trends.
This reversal strategy works well but much less powerfully in such markets. For this reason, there is a good understanding of such nuances and coupled with the use of tools like the RSI, in filtering out trades which can bring about an important advantage. Thus, though cumbersome to catch the perfect reversal, it is certainly possible, under the right strategy, to make the odds of profitable trades much higher.