In Forex, some specific price action patterns do occur frequently; traders for long utilise this pattern to enter highly effective trades. The reversal pattern is just one among those many price action patterns out there. Although the reversal pattern counters trend movement, it is very effective and can accumulate massive profits in a short while. But, making those massive profits only depends on how you understand the market. Many traders have recorded numerous losses while trading reversal patterns because they didn’t take proper precaution before entering a position if you are among this group I’m sure by the end of reading this article you will be able to account for your losses. In this article, you will get to know the ultimate guide in trading reversal pattern.
What are reversal patterns?
They represent price action movement that opposes a trending market; it is a type of countertrend strategy most technical traders uses. Reversal patterns are transitional phases describing the end of a bullish or bearish trend; it leads to the formation of a new counter-trend. For instance, in an uptrend or bullish trend as prices get to the reversal zone sellers start accumulating the market, if the selling pressure exerted in that zone is higher than the buying pressure, there would be a change in the trend. Technical analysts have long made use of reversal pattern to predict future market movement, although this prediction is not always right; having an effective risk management plan would make you gain massively and lose slightly on the long run.
HOW TO SPOT EFFECTIVE REVERSALS
Being able to accurately and effectively spot reversal is a reasonable and authentic ultimate guide of reversal pattern, spotting these reversals will make you take high probability trades which can lead to massive profits. There are times a reversal in a trending market would act as a fakeout, i.e. price will move out of the trending market temporary but later retrace and continue the trend; traders that make trades based on this temporary movement eventually loss enormously depending on the risk management plan they put in place. Spotting effective reversal is highly essential to prevent losses; the following will help you spot effective reversal:
- Reversal Candlestick pattern
- Range/ consolidation
- Breakthrough EMA ( Exponential Moving Average)
Reversal Candlestick Pattern
A candlestick is a representation of price movement on the chart; they are price bar that showcases changes in the price of currency pairs over a specified period which could be an hour, Four hours, a day, a week or a month. A candlestick reversal pattern is an arrangement consisting of one or more candlestick which can be used to predict future market action. There is a lot of candlestick pattern out there, but for the sake of this article, we will focus on the four most effective and widely used.
|Bullish Reversal Candlestick Pattern||Bearish Reversal candlestick pattern|
|1: Doji (Dragonfly, Doji cross)||1: Doji ( Gravestone, Doji cross)|
|2: Bullish Engulfing||2: Bearish Engulfing|
|3: Bullish Harami||3: Bearish Harami|
|4: Hammer||4: Shooting star|
1. The Doji’s:
The dojis is both an example of bullish and bearish reversal candlestick; they come in many ways depending on their position in the chart. Dojis are very short compared to all other reversal patterns; at the same time, they are beneficial for predicting and spotting effective reversals.
From the diagram above there are four types of doji, the first which is used in both bearish and bullish trend and also look very similar to long-legged Doji; the difference between them lies in the lengths of their wicks. As we could see in the diagram, long-legged Doji has a long wick, unlike common doji, and they both carry out the same function. The simple explanation to this particular candle formation is that; both buyers and sellers are exerting equal pressure on the market at that specific spot making the candlestick formation neither bearish nor bullish. We also note that the open and close position of the long-legged or common doji lies in the same place. Some traders will say “when you come across a long-legged or Doji cross you should either go long for a downward trend or go short for an upward trend” But, the fact is, you don’t trade Doji cross without confirming if future price action would eventually move in your favour.
From the diagram above price made a remarkable high, but on coming across the long-legged candlestick, it eventually fell considerable. I won’t advise you to make trades based on this, but as we go on into the article, you will learn how to trade these candlesticks effectively in correlation with the different reversal patterns.
The gravestone is a type of bearish reversal candlestick pattern, it has a long upward wick, and it represents that; when the candlestick was formed buyers pushed the market forward, but eventually, sellers came and exerted more pressure to drive the market back downward, making price close at the position where it opened. If this candlestick pattern is formed in an upward trend, it signals that there is a probability for a downtrend occurring as a reversal.
In the EURUSD chart above, we notice that price was currently making highs, but after it came across the gravestone, its direction was reversed. Sometimes these candlesticks are powerful when used to predict future market, but you should be careful not to take trades without overseeing price movement.
The dragonfly candlestick showcases the strength of buyers in the forex market; it has a long downward wick which further explains that in the formation of a dragonfly candlestick sellers were initially adding massive pressure to the market, but eventually, buyers came and they took charge over the market. The presence of a dragonfly candlestick in a downward trend can be a reliable spot for a reversal into an uptrend.
The USDCAD chart above showcases a downward trend which was later succeeded by an upward trend; this happened as a result of buyers accumulating the market due to the presence of the Dragonfly Doji, as we can see, as soon as the dragonfly candlestick was made on the chart buyers accumulated massively to push price several pips upwards.
2. Bullish and Bearish Engulfing:
Two candlesticks characterise this pattern with the second candlestick engulfing the first. The Engulfing pattern is divided into a bullish engulfing pattern and bearish engulfing pattern, with the bullish engulfing pattern representing a reversal into an uptrend or bullish trend and the bearish engulfing pattern representing a reversal into a downtrend or a bearish trend.
Bullish Engulfing, as shown in the diagram above; consist of two candlesticks with the red candlestick smaller in length and the green opening below the red and closing above it. This pattern shows a massive change in sentiment from bearish to bullish. The red candle which closed below it opening is regarded as a bearish candlestick. In contrast, the green candle which originally opened below the red candle but eventually closed above its opening is considered to be a bullish candlestick. The green candle was able to move upwards because of an increase in the buying pressure.
Note: It is not in all situations the engulfing pattern would be displayed as shown in the above diagram; sometimes the second candle may be lengthier than the one shown, but the main factor in distinguishing an engulfing pattern from others is if the length of the second candle fully engulfs the first candle. Also, the color of the candlesticks is not always red and green; you can change them depending on your preference.
From the diagram, we notice that price has initially been in a downtrend before an imbalance between sellers and buyers occurred leading to the formation of a bullish engulfing pattern which reversed the market sentiment to an upward moving trend. We also notice that the bullish green candle opened below the previous red candle and closed above it, this clarifies that it is an engulfing pattern. The bullish engulfing pattern is essential in spotting future reversals, and if used in correlation with other factors, it can lead to massive profits.
Note: The wick of a candle is as vital as the body. From the diagram above, it was the presence of the wick in the bull candle that made it longer than the previous red candle.
Bearish Engulfing is quite the opposite of bullish engulfing; in this case, the bearish candle becomes the one that engulfs the previous candle. The formation of this engulfing pattern is a representation that, sellers are making a move to dominate the market. A bearish engulfing pattern in an uptrend or a bullish trend may be a signal that a reversal is looming; a trader who understands this would immediately close out all opened position and will look into taking trades on the bases of the incoming reversal. Engulfing pattern is mainly used by countertrend traders to ascertain whether a bullish or bearish trend would be reversed most traders also use it as a confirmation to increase the probability of making winning trades.
From the diagram, notice that the bearish candle is longer than the bullish candle, it opens above the bullish green candle and closes below it, in other words, the red bear candlestick engulfs the previous candle. The trend was previously moving upwards, but after the formation of a bearish engulfing pattern, a reversal occurred.
3. Bullish and Bearish Harami:
The formation of this pattern consists of two candlesticks placed side by side with one longer than the other. The harami pattern looks like the Engulfing pattern, only that in the harami formation the previous candle becomes the one lengthier than the second candle; also, the second candle tends to open and close within the previous candle.
The harami pattern looks like a pregnant woman; you quickly remember and understand the concept if you look at it that way. Both patterns are useful in discovering potential reversal zones for future trades. The Bullish harami is formed in a downward trend to reverse the trend in the opposite direction. Anytime you come across a bullish harami, you should have it at the back of your mind that a reversal can showcase itself. The harami pattern is significant, as a trader, you will come across it always in your chart, and it can help you increase the amount of winning trades you take.
The USDCAD chart showcases a change in the sentiment of price from a bearish momentum to bullish momentum. The presence of a bullish harami pattern and other useful factors made the reversal possible. Anytime you see a bullish harami in a downtrend you should know that an uptrend is likely to occur.
The Bearish harami pattern, unlike the bullish, has a red bear candle within the body of the previous candle. They are also useful in spotting potential bearish reversals.
The EURUSD chart showcase a change in sentiment from a bullish momentum to a bearish momentum which can be due to the formation of a bearish harami pattern, thus anytime you notice a bearish harami pattern on your chart you should know that bearish momentum is likely to occur.
4. Hammer / Shooting star:
A hammer or shooting star pattern has a single candlestick with a lengthened wick. Hammer candlestick, as shown above, has a lengthened wick to the downside; at the opening of the hammer candlestick sellers accumulated the market pushing the candle considerably downwards after that the buying pressure was increased which eventually pulled back the candle upwards, the downward movement leads to the formation of a long wick. Whenever you come across a hammer candlestick in a downtrend, there is a possibility for the trend to be reversed to an uptrend.
A shooting star has a lengthened wick to the upward side, anytime you see a shooting star in an uptrend there is a possibility for a downtrend to occur.
Range / Consolidation.
In forex, there are times the market decides to oscillate between specific highs and lows with the lack of a trend, it usually occurs after a massive downtrend or uptrend, and they can be represented as a stretch of indecision. A range or consolidation can be used to identify a reversal, i.e. a change in momentum either from a downtrend to an uptrend or vice versa, in general, they are instrumental in spotting and asserting reversals.
From the diagram, we saw that price oscillated through a known support and resistance level for about five times, during this stage both buyers and sellers are opposing themselves, which is why it is called a period of “indecision”. Two things would occur when price enters consolidation they include:
- Price breaks support level to continue the downtrend.
- Price breaks the resistance level and reverses the trend resulting in an uptrend.
After the price has retested the broken support or resistance level, you can trade the market, but you should have an extra confirmation to the trend movement which can come in play by using candlestick patterns. Consolidation can be used to spot effective reversals.
EMA (Exponential Moving Average)
The exponential moving average is an indicator which is used to determine the movement of the price through a set of parabolic lines. They can be divided into various periods, but for the sake of this article, we will be looking at the 30 and 60 periods moving average. In an uptrend price moves above the 60 and 30 moving averages also the 30EMA lies above the 60EMA while in a downtrend price moves below the 60 and 30 moving averages, and the 60 EMA lies above the 30EMA. In consolidation, the price lies in between the 30EMA and 60EMA.
We can use the exponential moving average to predict or spot a reversal by taking note of the position between prices and the moving averages. A breakthrough the EMAS signals a possibility of a reversal occurring. To get more ideas on EMA you can check through: https://www.investopedia.com/ask/answers/122314/how-do-i-use-exponential-moving-average-ema-create-forex-trading-strategy.asp
Two important Reversal patterns you should know:
Reversal patterns can be divided into various types depending on its formation. There is mainly two reversal pattern utilised by traders frequently to make winning trades, and they all portray a reversal in a trending market. Each time the formation of a reversal pattern is seen on your chart, there is a high probability that a change in the sentiment of the market will likely occur.
The second ultimate guide of reversal pattern is being able to trade them effectively. Spotting reversals is just a means to an end; you must also be ready to trade these reversals by using effective reversal patterns. The most significant reversal patterns are:
- Head and Shoulders
- Double Tops and Bottoms
Head and Shoulders
Most expert traders will tell you to look for a head and shoulder pattern to ascertain a reversal. If you’ve ever gotten this advice I will encourage you to stick to it because there is a high probability of future price action moving in your favour, but this is not always the case, sometimes a reversal may display a fakeout that’s why you must formulate effective risk management plan.
The head and shoulders pattern occurs on the chart when a bullish or bearish trend is in the process of reversing. Most reversal traders are continually looking after the formation of a head and shoulder pattern to take trades based on some specific entry reasons; the formation consists of three peaks with the outside two being close in height and the middle being the highest.
The above is a simple graphical representation of the head and shoulders pattern. It is formed when the sentiment of a particular bullish trend is about to change; as a result, the market makes a massive high (Head); subsequently, it declines to a known support level to form a neckline. The right shoulder is formed as a result of buyers wanting to pull the market back to the original peak of the Head, but they failed, and eventually, the market got to the known level of the right shoulder and retraced back to the neckline.
How to trade Head and Shoulders pattern
Before trading the head and shoulder pattern, you must have gotten an entry reason, take profit target and a stop-loss point.
The above GBPUSD chart showcases the head and shoulder formation; from the chart, we could see that the market was currently in a bullish trend. Eventually, it formed the head and shoulder pattern and broke through the EMAS, which signalled a possible effective reversal. Before taking a trade like this, you must confirm if price movement supports any of the guidelines for spotting reversals mentioned above, in the GBPUSD chart we noticed that price move against the EMAS and broke through it which support one of the criteria for spotting reversals.
After price broke through the neckline, it continued and retested the line at both points E1 and E2. These two points are entry point where your trades can be taken; at point E2, we notice the presence of a hammer, which further confirms the reversal. Also for the first and second entry point, you can decide to place your take profit at previous support level (TP1, TP2), and your stop loss should be about 20 pips away from your entry point.
Inverted Head and Shoulders
This formation occurs in a bearish or downward trend and signals that the trend is about to be reversed to a bullish trend. In the formation of this pattern, the price reaches an extreme low which is also regarded as the Head, but eventually, buyers came in and pushed the market back upwards to retrace the neckline.
The diagram above is a graphical representation of the inverse head and shoulders pattern. They are very useful in determining future bullish reversals. At the formation of this pattern, buying pressure is significantly increased to push the market in the opposite direction.
How to trade inverse head and shoulders
Trading inverse head and shoulders are nothing different from how we traded the standard head and shoulders pattern above.
From the chart above we can spot the inverse head and shoulder pattern, notice how I placed my entry point E after price broke and retested the neckline; also, by using the bullish engulfing pattern I was able to assert the effectiveness of the reversal. Take profit TP was placed at the previous resistance level, and as usual, your stop loss can be placed 20pips away from your take profit. Whenever you come across a reversal pattern like this be sure to follow the procedures on the chart for setting your entry point, take profit and stop loss.
Double Tops and Bottoms
Double tops: This is another crucial reversal pattern that consists of two upward peaks at about the same level; these peaks are formed as a result of the massive interaction between buying and selling pressure. The two peaks make a unique resistance level which serves as an essential point for entry reasons.
The above is a graphical representation of double tops, as we can see the market made an obvious high (1st peak), after that it pullback back some distance and later retraced back to the level of the first peak to form a second. The position of both peaks is considered as a resistance level.
How to trade double tops
Trading double tops pattern can be done in two ways either you trade based on the break, continuation and retest of the neckline, or you trade after the formation of the second peak. But I would advise you to stick to the first method.
From the diagram above, notice the formation of the double tops after a massive bullish momentum, consequently price made a downward trend. At the second peak, you can spot a shooting star which is an important reversal signal, this is a confirmation that bearish momentum is looming, but before opening an entry at this point wait for the price to form the next candlestick and if it is a bear you are good to go. The second entry point E2 can also be at the break and retest of the neckline, notice the presence of a bearish engulfing pattern. Immediately after price retested the neckline and formed a candlestick pattern, a sell trade should be taken. Take profit should be placed within the previous resistant level, and stop-loss placed 20 pips away from the entry point.
Double bottoms: it is very close to the double tops pattern, but unlike it, double bottoms are usually formed in a downtrend, and it depicts future reversals into an uptrend. Double bottoms consist of two conspicuous lows and a neckline above it.
The GBPUSD chart above showcases double bottoms formed in a downtrend; at this point, the market sentiment is likely to change reversing price to a bullish trend. The entry reason for taking trades based on this reversal pattern is on the break and retest of the neckline, as we can see from the diagram at the point where price retested the neckline after the break, an entry point E was placed, a confirmation pattern “Doji” also formed alongside the retest which proved the effectiveness of the reversal.
Note: When trading reversals you should be extra careful not to trade blindly; make sure you look out for confirmatory signals like candlestick patterns and EMAS formation that can assert the effectiveness and surety of a reversal.
In conclusion, trading reversals effectively can amount to massive profits, but to achieve this, you must make sure you take all the guides of the reversal pattern mentioned above into consideration. Do not trade reversals blindly; anytime you come across a reversal pattern, ensure you take accurate measures to confirm the effectiveness of the reversal and to see to it that price eventually moves in your favour.