Author: Shanda Biggs
In todays blog post we are going to show you how to accurately identify a reversal in the market. Picking up on important reversal points in the market is not always easy but with the helpful tips we are about to give you we hope it will make it easier for you.
What is a Reversal?
Before digging into how to trade reversal patterns we are going to explain what a reversal is. I am sure by now you are an educated enough trader to know that the market moves in cycles.
We are either in a trending phase or a pullback phase. When the market is not in a trending phase or a pullback phase, it is a ranging market. In a trending market we are making higher highs and higher lows and the pullback phase of those higher highs and higher lows can give you excellent opportunities for reversal trades. The opposite would be true for a down trending market such as the one in the example below.
To illustrate what I mean take a look at the image above. We can see that price has been in a beautiful trend making lower highs and lower lows. After price forms a new low and begins its pullback phase is the point where we can look for a counter trend move.
This is one area where reversal trades are abundant. Of course we want to ensure we stack the layers of confluence in our favor before taking any types of reversal trades because we are trading against market momentum. We will discuss more of these confluence factors later in the post.
So to summarize, a reversal is any point in the market where the current run or trend is pausing and price reverses in the opposite direction of the current trend.
When do Reversals Happen?
Not only is it important to know what a reversal looks like but it is equally as important to know when and where they occur in the market so that you have the highest probability of success.
The highest probability reversals happen when the market is in an overextended trend or run. When we say over extended what we are referring to is the trend has been going up or down for quite a while. It is clear that price cannot head in the same direction forever and this is why after long periods of trending markets it is imperative to keep your eye on points where the market could reverse. To give a visual of what I am referring to we will look at EURUSD. As you can tell when price broke out of the consolidation on the upper half of the chart it has made a clear plunge to the downside.
Price has been dropping and dropping for almost a month. It is wise to understand that the market will never head in the same direction for a long period of time so when we see price starting to slow down it is our best bet to look for reversal opportunities. As we fast forward in time we can see that price formed a large engulfing bar after a long downtrend. This is our first clue that the market may be reversing. This strong candlestick price action pattern is a big clue into where the market could potentially be heading next.
For an intelligent trader, we know that just trading an engulfing bar after a run in price is a decent setup but we are looking for something more. We want to see more confluence in order to take our long position because the overall market momentum is against our position.
What we can look for now is support and resistance, over sold signals, or MACD divergence (or a combination of the 3). Pairing these confluence factors with our initial setup supports our trade even more. We can be more confident in our direction predication and possibly look at taking a trade.
You can see in our EURUSD example that this engulfing bar formed at recent daily support and this adds confluence to our trading setup.
How to Identify a Reversal
Now that we understand when to look for reversals we need to know exactly what to look for. We have touched on this earlier in the post but now I want to give you the exactly tools laid out so that it is easier for you to look for these types of setups in the market. Here is a check list that you can use when looking for reversal trades.
1. Look for an exhausted trend or a daily chart that has had several candles of the same color in a row (to show an overextended daily trend)
2. Watch for a strong price action pattern such as an engulfing or pinbar (to learn how to identify pinbars and engulfings see our other great post)
3. Always ensure to look for the above to criteria WITH support and resistance or some other type of indicator to show that the trend is indeed reversing
You have probably heard the term “Don’t try to catch a falling knife.” This is very applicable to trading reversal setups. If we do not have the factors of confluence in our favor what we are doing is trying to catch a falling knife. Instead we stack the confluence in our favor in order to justify a trade. This helps us to always take high quality trading setups.
Now looking at EURUSD a few days later we can see that our trade would have gone into profit. By looking for strong candlestick patterns in combination with other price action tools such as support and resistance, bollinger bands and MACD divergence you can identify and trade these strong reversal setups.
Another important point to note is not only entering the trade with proper criteria but also exiting the trade. This can be the most important part of your trading routine because if you do not have carefully planned exits, your entry does not matter much.
It is especially important to know where you are exiting when trading reversals. Why? We are not looking for a full trend change at this point so we need to plan our exits very carefully. What we want to do is exploit the natural pullbacks of the market. Since we are fighting the natural momentum of the market it is wise to have smaller take profits. Once our profit target is hit we can then take our money off the table and await the next opportunity. Common take profit levels could be a standard 1:1 risk reward, Fibonacci extensions or an ATR factor. Whichever you decide to use be sure that you understand why you are taking profit at the particular area and ensure that you have an edge using that method.
At Evestin Forex we have developed a very successful trading strategy that utilizes all 3 points on identifying reversals. First the strategy looks for high confluence candlesticks at the extremities of price action. We utilize bollinger bands to do this and the results have been nothing short of amazing. To learn more check out the strategy and others that we trade by downloading your free ebook here. Our strategy is powerful and if you want to give it a test, you can sign up for a FREE 30 day trial by clicking the button below.
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