Reversals In Forex - How To Identify And Trade
Reversals refer to a change of direction in a market. If the market is in an uptrend then a reversal would lead to a price decline, if the market is in a downtrend then a reversal will lead to a price increase.
Reversals within a range
Now that we understand the basic definition of a reversal, and what it looks like on a chart, it is time to get into heavy lifting. Here is what follows in this article:
- Why do reversals occur in the Forex market?
- How to identify reversals?
- Trading these occurrences.
- Differences between reversals and retracements.
- Other important points.
Why do reversals occur in the Forex market?
Forex (like all markets) is driven by supply and demand. When demand (buying) outweighs supply (selling) the market will move upwards. When supply (selling) exceeds demand (buying) the market will fall.
By extension, an uptrend will reverse when demand dries up and the sellers overpower buyers. A downtrend will end when supply dries up and buyers take control from the sellers.
How to identify reversals?
You may find it extremely easy to look back at charts and see where reversals occurred, however, all traders know it is far more challenging to determine when the market is reversing in real-time.
Fortunately for us, we can look towards several different forms of technical analysis to help gauge potential price shifts.
1. Price action
Uptrends are formed by a series of higher highs and higher lows, therefore if price moves below a higher low then this is a warning sign that a significant reversal could occur.
Downtrends are formed by a series of lower lows and lower highs, should the market break above a lower high then the overall direction could be shifting to the upside. Thus you can use simple price action as a sign of a potential price shift.
Break of higher low in an uptrend
Break of lower high in a downtrend
Breaks of these swing points are significant because they indicate a supply and demand shift, i.e. bulls are unable to sustain their buying (making further highs) or bears are unable to continue selling (making further lows) and consequently the market turns.
2. Major support and resistance zones
Reversals often occur within major support and resistance zones. To ensure the zones are strong look for many historical inflection points and focus on the larger timeframes when analysing.
Reversals at support
Reversals at resistance
Bearish trendline break
Indicators such as RSI and Stochastics let us know when the market is overbought or oversold. If you are not aware of what these terms mean – Overbought means that a bullish move is overextended and a downward move could be on the horizon, oversold means that a bearish move is overextended and an upward move could occur soon.
I am sure you would leave this article disappointed if we didn’t look at some ways to trade reversals by using the identification techniques mentioned above. That is up next.
Trading these occurrences
Successful Forex trading (or any form of financial instrument) is dependant on probabilities. Because of this, some of the strategies require a confluence of technical analysis tools to justify a trade.
Some of you may have been surprised that I have not mentioned candlesticks yet, this is because using only candlesticks to justify a reversal trade will leave you with empty pockets. However, candlesticks are still extremely powerful as they assist in timing entries and preventing losing trades.
How can candlesticks do this? By analysing these charts, we can see if the market agrees that a reversal could occur (they act as confirmation). Furthermore, by focusing on the close of the candlestick Forex traders can avoid entering on false signals.
1. Trading using horizontal breaks
Once price breaks past a higher low (in an uptrend) or a lower high (in a downtrend) you can place a breakout trade. Wait for a strong candlestick to close past the level and then place a trade in that direction.
If you prefer trading with a higher win % then you can choose to wait for price to retest the level and then wait for confirmation to enter.
2. Trading using major support and resistance zones
Next up, we have a very basic approach, trading reversals using support and resistance. Essentially what we are looking for are strong zones as well as candlestick confirmation.
Stop losses should be placed past the zone and take profits at the next major support or resistance point.
The above trade is an example of a double top.
3. Trading using trendline breaks
As mentioned, trendline breaks indicate a likely shift in supply and demand. Thus when a trendline is broken, there is an excellent opportunity presented to trade in that direction. All you have to look for is a strong candlestick close past the trendline.
Place the stop loss above/ below the breakout candlestick and the trendline. Take profits are the same as horizontal breakouts, either at the beginning of the previous trend or the next significant level.
Trendline breakout trade
Again, if a higher win % is vital to you, then you can also wait for a retest after a trendline breakout.
4. Trading using indicators
Indicators alone are not enough reason to place a trade but they still offer value in gauging the flow of the Forex market. Therefore if we look for overbought or oversold signals at a level, there is a good probability of a profitable trade.
Place your stop above the zone and take profit at the next major level.
Difference between reversals and retracements
Retracements are temporary reversals within a trend, after a countermove price continues in the overall direction.
Reversals refer to a complete shift in the direction of price. After a reversal, the market continues to move in the opposite direction to the previous trend/ impulse.
For traders to make a profit, it is crucial to gauge whether a price move is likely the beginning of a reversal or just a retracement within an overall trend. Here are some ways to do so:
- Retracements usually occur on lower volume.
- Reversals are more likely if price has already moved significantly in one direction.
- The market is more likely to change direction if a certain level, trendline, or other tool is from a higher timeframe.
Other important points
- Reversals are relevant to all traders (not just those who trade them) because the market can turn against an open position (no trader enjoys their profits being eaten away).
- Remember that a reversal on one timeframe could be a retracement on another, I suggest you implement multiple timeframe analysis to be aware of this.
My fellow traders this brings us to the end of the article. As I just mentioned, it is essential to understand reversals whether you trade them or not because the Forex market can turn on you in an instant.
Reversals can be your friend too.