The Red Dog Reversal is a trading setup which aims to catch a reversal in a downtrend.
What is a Reversal?
Before we get into the details of this specific trading setup, let’s get clear on what a reversal trade really is.
I think of it like this: you can boil down a lot of the complicated jargon and concepts of technical analysis into dividing price action into two states: trends and ranges.
In trends, you’re looking for momentum, where the price changes very fast in one direction. Beyond technical definitions, momentum is when one side of the market (buyers or sellers) are very aggressive in pushing price in one sustained direction.
In ranges, you’re looking for mean reversion. When the price deviates from the recent average price, that move is typically faded by traders, expecting a reversion back to the mean. If prices aren’t mean reverting, you might be seeing the early stages of a trend developing.
So the key characteristic that determines the strength of a trend is momentum, and the key characteristic that defines whether a range will continue is mean reversion.
When the market transitions between a trend and a range, you see some very interesting activity.
Typically, both volume and volatility increase as the status quo of the market has been disrupted, and traders are rushing to the entries or exits to reposition themselves.
Generally, the way that a range transitions into a trend is through a breakout. The market sits in a tight, boring range until nobody cares.
Then, an impulse of energy is shot into the market and the traders who forgot are rushing to get in. Breakouts occur because a lot of aggressive buyers want to buy at once and there simply aren’t enough sellers present to meet their demand, so an aggressive repricing on the part of the sellers occurs.
The more interesting transition for this article is when a trend transitions into a range, or even another trend.
This is called a trend reversal, and the Red Dog Reversal is one type of trend reversal.
This is when the state of the market is suddenly interrupted and it becomes clear that the previously established trend is over, leading to an aggressive repositioning.
What is the Red Dog Reversal?
The Red Dog Reversal is a trend reversal trading setup which aims to buy stocks that are potentially reversing out of downtrends when they test and reject their lows.
Here are the parameters of a Red Dog Reversal:
- Stock is downtrending
- Stock makes a new lower low (A)
- On the following day, the stock trades below the low A and makes a new low (B), but the market rejects this low and the bulls aggressively buy to push it above the low at A.
- When the market initially trades below low A, set a buy stop a tick (cent) above low A.
- Set stop loss at low B.
In picture form, it might look like this:
You’re looking for a bar that tests breaking below Low A, briefly makes a new low but the market quickly rejects the low prices and rallies above Low A.
Once the bar breaks below Low A and makes a new low, you set a buy stop at Low A and a stop loss at Low B. It’s a simple overextension trade.
Goals of the Red Dog Reversal
The Red Dog Reversal trade setup aims to capitalize on mean reversion, which is a very strong force in US equity markets.
An easy way to explain mean reversion is to imagine a moving average and when a stock strays too far away from the average, there aren’t enough sellers down at those prices, so buyers take control and push the price back to an equilibrium price closer to the moving average.
Mean reversion typically occurs when the price of a stock has moved down too much too fast, likely due to a short-term panic like bearish news, or even simply a big seller that had to unload fast and couldn’t stand around waiting to get a better price.
The key factor with the Red Dog Reversal trade is that the goal is not to join a new trend in the opposite direction, but instead identify points where the rubber band has stretched a bit too far in one direction and hop aboard the market for 2-3 bars as it snaps back to equilibrium. These are more scalps then trend trades.
Example of a Red Dog Reversal
Below is a textbook example of the Red Dog Reversal setup in Becton, Dickson and Company (BDX):
Let’s consult our checklist:
- The stock is in a downtrend
- The stock made a new low (Low A)
- The stock tested below Low A and was quickly rejected
How To Screen for The Red Dog Reversal
In the interest of practicality, we’re going to look at a basic screen using FinViz, a free web screener everyone has access to.
It couldn’t be more simple, we’re looking for stocks that are making new 50-day lows. This ensures the stock is in a downtrend. Additionally, I added a market cap filter to ensure the results are made up of fairly liquid stocks, however, you can change that filter to what you’d like.
From there, you want to set the FinViz view format to “TA”, as you can see in the toolbar right below all of the screening parameters. This allows you to quickly scroll through a bunch of charts and pick out the good candidates.
You don’t need any fancy screeners that analyze order flow or anything. Any screener that can look for new 20 or 50-day lows is just fine. If you apply a market cap filter, you’ll get a very manageable list of stocks you can look through in minutes.
From there, make a list of the stocks that look like compelling Red Dog Reversal setups on a watchlist, and watch for them to set up Red Dog Reversals at the market open.
The Red Dog Reversal is a soup and nuts simple reversal trading strategy. It gives you some basic parameters so you know exactly what is a setup and what is not, but doesn’t get too bogged down in details.
It’s worth noting that the Red Dog Reversal is extremely simple to the “Open, Test, Reject” opening type in market profile.
If you’re unfamiliar with market profile, it’s a form of technical analysis that has some interesting ideas that might be new to the traditional technical analyst so it’s worth checking out.
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Original source: https://www.warriortrading.com/red-dog-reversal-strategy/