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 can also occur within ranges, but instead of changing direction after a trend in a definitive direction, the market is reversing an impulse wave (made up of a smaller timeframe trend).

 

Uptrend reversal

Downtrend reversal

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

3. Trendline breaks 

Trendlines do a great job at identifying turns in the market, but how? Us traders can use trendline breaks as a sign that buyers or sellers cannot sustain their power over the other side, thus momentum could be shifting in the other direction.

 

Bullish trendline break

Bearish trendline break

4. Indicators

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.

 

Overbought RSI

Oversold Stochastics

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 breakouts

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.

Stop loss above/ below the level as well as the breakout candlestick and take profit either at the beginning of the previous trend or the next support/ resistance zone.

 

Breakout trade

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.

 

Using levels

The above trade is an example of a double top.

 

3. Trading using trendline breakouts

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.

 

Using indicators

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.

Are you interested in trading reversals? If it is your cup of tea, and you want to trade ASAP, then open an account with AvaTrade and get started now. 

Reversals can be your friend too.

Reversals FAQ

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.

The forces of supply and demand are constantly changing in a financial instrument. If one side gains strength while the other weakens, a reversal will occur.

A reversal means the market has completely changed direction, while a retracement is a temporary pause in a trend before it continues. Reversals usually occur on high volume and retracements on low volume.

Analyzing price action, using support and resistance levels, trendline breakouts, and indicators can help you identify a possible reversal.

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Guy Seynaeve

Guy Seynaeve

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