At the tail end of a bearish global and local market, fresh economic catalysts start to emerge. During this transition period, company earnings begin to recover, consumer spending surges and inflation stabilizes at lower levels. In the lens of Technical Analysis, this will be expressed in the charts as major bearish to bullish reversal patterns wherein steep downtrends shift to strong and stable uptrends. This is the time when traders become aggressive and make the most amount of money.
Veteran traders understand that the quick and easy money is gained during strong momentum setups. When the general investing public is aggressively buying, prices surge and form sustainable uptrends.
In this post, we will provide practical tips to help you recognize momentum setups as they begin to form after overextended downtrends and consolidations.
1. Momentum Shift after a Bullish Divergence Reversal
A breakout after a bullish divergence reversal is one of the most common momentum shift formations that can be observed whenever the general market recovers from an overextended downtrend.
In the chart above, you can see a steep downtrend move with EMA9 as the dynamic resistance. Notice that the downtrend is disrupted after a bullish divergence reversal pattern has formed. As the price breaks out above the trendline resistance, it created a role reversal bounce wherein the previous trendline resistance is now acting as the trendline support. As such, buyers are now in control and fully shifts the trend to an uptrend.
Here are the key price action elements of this setup:
Reversal pattern at the bottom of the downtrend - Bullish divergence
Trendline breakout (preferably with above average volume)
Role reversal bounce (previous resistance acting as the new support after the breakout)
Higher low bounce
EMA9 continually acting as the dynamic support
Here are the safe entry points for this setup:
Buy on breakout if it is validated by above average volume
Buy on role reversal bounce
Buy on higher low bounce (pullback must be validated by decreasing volume)
2. Momentum Shift after an Inverted Head and Shoulders Reversal
An inverted head and shoulder reversal is usually a medium term structure. Meaning, it may take several months to form. As such, a lot of patience is needed before the price fully breaks out and shifts to momentum.
In the chart above, you can see a choppy downtrend move with several upswings and downswings. At its tail end, an inverted head and shoulders pattern forms indicating a major reversal move. This is followed by a strong trendline resistance breakout which is validated by above average volume. After the role reversal bounce, the price action fully shifts to a momentum setup.
Here are the key price action elements of this setup:
Reversal pattern at the bottom of the downtrend - Inverted head and shoulders
Trendline breakout (preferably with above average volume)
Role reversal bounce (previous resistance acting as the new support after the breakout)
Higher low bounce
EMA9 continually acting as the dynamic support
Here are the safe entry points for this setup:
Buy on breakout if it is validated by above average volume
Buy on role reversal bounce
Buy on higher low bounce (pullback must be validated by decreasing volume)
3. Momentum Shift after a Base Formation Breakout
A more aggressive and sudden momentum shift setup is the one that follows after a prolonged base formation structure.
Usually, this setup happens in a dormant stock that has been consolidating for a long time. Suddenly, a strong piece of catalyst is announced and an overwhelming demand for the stock results to an explosive breakout.
In the chart above, you can see a strong parabolic rally happen after the first breakout candle forms which is supplemented by above average volume. After which, volume further surges and pushes the price to multiple double digit daily spikes.
Bear in mind that this setup is very risky if you have not caught the initial breakout move. As the price climbs up near RSI80, the risk exponentially increases.
Here are the key price action elements of this setup:
Resistance breakout (preferably with above average volume)
Succeeding candles after the breakout show increasing volume
Contracted consolidation candles and numerous long bullish engulfing candles
EMA9 continually acting as the dynamic support
Here are the safe entry points for this setup:
Buy on breakout if it is validated by above average volume
Buy on pause candles as long as EMA9 is supporting the price (higher base formation must be validated by decreasing volume)
Buy on higher low bounce (pullback must be validated by decreasing volume)
How to Maximize a Momentum Shift
As the price breaks out from an overextended downtrend, a trader can maximize the momentum shift by executing the following:
Wait for the volume to validate the breakout always. Do not rush to buy!
Buy on breakout as long as it is validated by above average volume.
Hold and add more when it creates a role reversal bounce. This means that the buyers are now in control.
Monitor your trailstop always when trading a momentum setup. You can use EMA5, EMA9, a percentage basis stop or a Fibonacci grid as your guide.
Sell in tranches when bearish reversal patterns form.
Sell in tranches when dynamic support levels break down with above average volume and form lower low candles in the next days.
The Bottom line
There is an exact time to be defensive and aggressive in the market. When prices are forming steep downtrends with heavy selling volume, traders opt to stay light and be defensive. But when the price reverses and shifts to an uptrend move, then traders step on the gas pedal and shift to an aggressive stance.
Let the market show you the way. Proper use of technical analysis will allow you to spot the proper reversal signals and patterns for you to gauge when to buy or when to just sit and wait. When done properly, momentum setups will allow you to compound your capital quickly with little to no stress.
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