There are three main types of price movements: trends, continuations and reversals. Understanding all three types is essential to being a well-rounded trader. In this article, I will explore reversals to help you build a solid foundation in price action and technical analysis, which should help make you a more profitable trader.
As the name suggests, trend reversals are reversals in the direction of price. Understanding how to trade reversals means you can enter a whole new trend near its beginning or exit the market before it goes in the opposite direction.
Let’s get started.
A trend reversal is when the price reverses the trend.
In the area of the circle, the price will form a “reverse pattern”. A reversal pattern can be fast with little volatility or it may take a long time to form with a lot of volatility. Twists come in many forms, so let’s look at some methods you can use to identify these patterns.
Method 1: Break in the trend
There are two types of trend breaks:
- Last significant break support or resistance.
- Trend line break.
Breakout of support or resistance in a trend:
- Pros: I prefer this method over the trend line break because it is more reliable. A support or resistance level shows a key buy or sell at a particular price level, and when the price breaks that level, it signals that that segment of the trend is “officially” over.
- Disadvantages: If the previous support or resistance in the trend is far from the current price level, I can lose a significant amount of profit before I realize that the trend is over.
Trend line break:
- Pros: A trendline can give an earlier signal than waiting for price to break previous support or resistance.
- Disadvantages: There are more false trend line breaks in a trend compared to false breaks of support or resistance levels. I constantly redraw trend lines because price breaks my previous trend line, but price often continues in the same direction.
A trend break, whether from a trend line break or a support/resistance break, does not mean that the price will automatically change direction. The price could instead go sideways and then continue the previous trend. To be sure of a reversal, it is better to wait for a new trend to develop in the opposite direction.
Method 2: Chart Reversal Pattern
Let’s look at some key types of reversal patterns.
Double and triple tops: These are the easiest patterns to recognize in technical analysis because they are the simplest.
Double Top/Bottom: Price reaches the same level twice to form support or resistance before reversing direction.
Triple Top/Bottom: Price reaches the same level three times to form support or resistance before reversing direction.
Which is better – double or triple top/bottom? A triple is better than a double top or bottom because the price has rejected the level multiple times, showing stronger rejection sentiment.
The size of the pattern is important: For example, a larger double peak is a stronger signal than a smaller triple peak.
Let’s look at the double top example and break down the real deal. I will take this trade step by step to show how the price action and the double top pattern beforehand showed a clear trend reversal.
- The price is moving in a nice uptrend, but suddenly accelerates when it reaches a new high. The acceleration in price should be a warning that an equally steep decline could occur. That’s exactly what happened here – the price sold out very quickly. At this point, it’s too early to know if the price will double.
- After that, the price reaches the previous high and forms a “rounded top” formation, creating a double top. A wrap top is a strong pattern on its own, and even stronger when part of a larger pattern like a double top.
- After the rounded top, the price quickly sells off, showing a clear bearish sentiment.
- At this point we can sell into the download, perhaps using Fibonacci retracement levels find records. The price makes a series of lower highs, indicating a downtrend.
The head and shoulders pattern consists of three upper parts, but the middle upper part is higher than those on either side, representing a head with two arms beside it. Reverse this logic for an inverted head and arms with the bottom lower than the two arms next to it.
Is necessary wait for the price to break the neck to complete the pattern. Before the neckline breaks, it is only a potential head and shoulders pattern, not a full reverse pattern.
Here is a great example of a head and shoulders pattern on the AUD/USD daily chart.
Notice how price retested the neckline as resistance (indicated by the white arrows). This provides excellent entry opportunities, especially the second retest as it is a healthy bear pin bar.
Good chart patterns can take some time to complete. In this example, the completion of the AUD/USD head and shoulders pattern was about 150 candles (six months)! Of course, in smaller time frames, the time to completion would be proportionally shorter. For example, a head and shoulder pattern with the same number of candles on an hourly chart can take several days to complete.
Double Sided Patterns: They usually are triangular formations.
The tricky thing about these patterns is that they can be either continuation patternsi.e. continuation of previous trend direction, or reversed patterns. We need to wait for the price to break through one side of the triangle to determine if a reversal or a continuation is more likely.
Here is an example on a 4-hour EUR/USD chart.
So far I have only looked at pure price action – the cornerstone of technical analysis. This means that the indicators can provide crucial clues for assessing direction. Let’s look at the most used indicators for identifying trend reversals.
Moving averages, or MAs, are the most popular type of indicator in technical analysis, and trend traders love them because they quickly show where price is in relation to its momentum.
How is a moving average calculated? The moving average calculates the average closing price of the specified number of candles. For example, a 10-period moving average calculates the average closing price of the last ten candles and plots this data as a line.
Types of moving averages:
- The simple moving average (SMA) calculates a simple average or “average” of the closing prices.
- Exponential Moving Average (EMA) gives more weight to the latest closing prices.
How to read a moving average:
- When the price is above the moving average, it has an upward momentum.
- When the price is below the moving average, it has downward momentum.
Using two moving averages: Placing a single moving average on a chart and watching the price fluctuate around the line is not a sophisticated way to get price momentum information. A better way is to place two moving averages on the chart:
- AND fast MA calculates the line using fewer closing prices and is seen closer to the price. AND slow MA calculates the row using a larger number of closing prices.
- When the fast MA crosses the slow MA it’s a bullish signal from below.
- When the fast MA crosses the slow MA above, it is a bearish signal.
golden cross moving averages: A popular moving average setup is the 50 EMA and 200 EMA on the daily chart. These settings are called “golden cross” or “bullish cross”.
Here is the gold cross in action on the USD gold daily chart. I happen to be looking at Gold for this, but it has nothing to do with the name, golden cross! I can use golden cross setup on Forex pair, stocks, etc. The golden cross has been a very effective long-term buy signal in the S&P 500 in recent years.
The gold cross on this chart nicely shows how it captured the long bullish trend starting in 2019 when the 50 EMA crossed the 200 EMA from below. It would keep you in the trade until early 2021 when the 50 EMA crosses the 200 EMA, this time from above.
Other trend reversal indicators: Moving averages are not the only trend indicator. It is also commonly used by traders MACD (derived from moving averages) and pivot points to identify trend reversals.
I’ll break it down into a step-by-step process using the ideas presented so far in this article.
Step 1: Identify the trend. Make sure it’s clear and mark rising supports if it’s an uptrend or falling resistances if it’s a downtrend. A trend can also have a clear trend line.
Step 2: Wait for the trend to break. For example:
- Price breaks the last support for an uptrend or resistance for a downtrend.
- The price breaks the trend line.
- Momentum indicator it can also help signal that a trend has ended.
Step 3. Look for confirmation that the price will change. The price can immediately begin to reverse with a new trend. More often, however, there will be a reverse pattern, e.g. a double/triple top or bottom or a more complex chart reversal pattern such as a head and shoulders or rounded top/bottom pattern.
When trading Forex reversals, there are often clear technical signals that the trend has ended and a new one in the opposite direction is about to start. Walk through the step-by-step process of identifying critical trend areas: horizontal support and resistance levels and trend lines. When the price breaks these levels, the trend segment will most likely end. This does not automatically mean that the trend will reverse – the price could go sideways for a long time – but the previous segment of the trend is over for now. The price must create new momentum either in the original direction of the trend or in the opposite direction.
How do you confirm reversals?
You can confirm reversals when the previous trend has broken and the new trend has started to move in the opposite direction.
What type of indicators are used to find market reversals?
Moving averages, MACD and Pivot Points are the most popular indicators used to find market reversals.
What is the best indicator for reversals?
Moving averages are widely considered the best indicator for identifying reversals.
What are turnover rates?
The reversal indicator helps to show that the price is reversing direction from the previous trend direction.