Trading trend reversals

A Guide to Trading Trend Reversals

As a trader, it’s important to know how to spot trend reversals. It’s particularly necessary if you’re a reversal trader but even as a trend trader, it’s useful to know how to spot a reversal. Indeed, as a trend trader, a looming reversal might very well be the moment to take profits and get out.

Trading trend reversals

 

But after years of trading reversals, I know that it’s often much more subtle than just seeing the price change direction. Not all reversals play out in the same way. There are multiple types of reversals, each with their own characteristics.

 

Some reversals are gradual and look textbook. Other reversals are very unpredictable, volatile and hard to trade. Even others will look like a reversal but eventually continue on their trending path, taking out many traders along the way. Knowing what is what can be the difference between a losing and a profitable trader.

 

 

Candlestick Pattern vs Chart Pattern Trend Reversals

 

Some people will think about reversals and think: pin bar! While the pin bar is definitely a typical reversal candlestick pattern, that’s not the type of reversals I’m going to be talking about here. I usually make the distinction between candlestick reversal patterns and chart reversal patterns.

 

Candlestick reversal patterns are usually reversal patterns composed out of 1 to a couple of candlesticks. Pin bars are an example, but also engulfing bars are candlestick reversal patterns.

 

Candlestick patterns vs chart patterns

 

In my experience, candlestick patterns are not as reliable than chart patterns (like a head & shoulders pattern). I do use candlestick patterns, but rather as entry triggers than as the basis of my reversal setups.

 

For example, let’s say I’m looking at a good double bottom setup. When I see an engulfing bar that at the same time breaks the double bottom neckline, that is usually a good trigger to enter a trade. However, the engulfing bar in and of itself isn’t enough for me to enter a trade, it has to happen in the right chart context.

 

 

Sharp vs Gradual Reversals

 

To start off with, we can divide all reversals into two broad categories: sharp and gradual. Gradual reversals often look like a rounded half-circle or feature some gradual form. You will see a rounded top or rounded bottom and then a push in the opposite direction. Often, they will feature certain chart patterns, such as a head and shoulders formation. Typical for a gradual reversal is that you see many regular-sized trend waves, followed by an area that could be defined as a range, and then a wave pattern in the opposite direction.

 

Sharp vs rounded reversals

 

On the other hand, sharp reversals will either feature a V-shape (or upside down V-shape) or another strong and sudden reaction. A strong push in one direction, followed by an equally strong or stronger push in the opposite direction. The market behaviour we see with sharp reversal often will exhibit things like exhaustion candles (a strong, final push in one direction before exhaustion hits and price reverses) and strong demand or supply zones that have the buying or selling power needed to put in motion a sharp reversal.

 

I’ve found that while the potential reward can be good on these sharp reversal trades, they’re often unpredictable and have whipsaws that can easily take stops out, before going in the opposite direction. There are definitely ways to trade sharp reversals and I know traders who do exactly that, but I’ve never gotten into them and as such, I usually avoid sharp reversals.

 

 

Reversal Phases

 

Before we go deeper into the different types of reversals, I’d like to go over an additional definition: the trend reversal phases. Usually, you can categorise a reversal in multiple phases, all featuring distinct characteristics. Many of these phases have been defined in Dow theory but for this article, we don’t need as much granularity.

 

For the sake of simplicity, trend reversals usually have three distinct phases:

  • initial trend phase
  • consolidation / ranging phase
  • reversal trend phase

 

Here’s an example of a chart with the phase markup:

 

Phases of forex trend reversals

 

Let’s go over the phases, one by one. Remember that this is how I trade trend reversals. While this works for me, other traders might be looking for other things and still be successful. What I’m describing below is, therefore, my view on trend reversals.

 

1. Initial trend phase

 

The initial trend phase is what I’m looking for, before anything else. I want to see a nice (up- or down-) trend, with the following characteristics:

 

Overextended: the trend has been going on for quite a while and we are in the latter stages of the trend. These stages are often characterised by the price reaching higher Fibonacci extension levels (161.8%, 200.0%, 261.8%) and will often feature strong trend exhaustion bars (or what Dow theory would call the excess phase). While an overextended trend doesn’t guarantee a reversal, it does set up the stage in the best possible condition for a reversal to potentially happen.

 

Overextended trend before trend reversal

 

Low to medium volatility: this volatility filter basically often prevents you from getting whipsawed by candle spikes. Low to medium volatility means that, while there is still some movement in the price, it moves in a predictable way. This volatility requirement goes hand in hand with the next characteristic of what I’m looking for:

 

Clean trend waves: In the initial trending phase, I prefer to see a trend that has multiple trend waves that behave in a clean, repeatable pattern. But what does “clean” exactly mean? Let’s use an example, which of the following two trends would you define as clean?

 

Messy vs clean charts

 

Now, a follow-up question: which one of these trends would be the easiest to trade? I definitely prefer the one on the right, as it is much less likely to get whipsawed on that one by a sudden price spike. Of course, what is clean vs what is messy is something that you will have to learn for yourself. After you watch enough charts, you’ll get a feeling of what you should be looking for.

 

One final note: it’s not because the initial trending phase is clean, that the potential reversal will be too. Market dynamics shift and the volatility of a pair will go up and down, changing the structure of price action. But starting with a clean trend sure beats that mess on the left side of the previous chart!

 

 

2. Consolidation / Ranging Phase

 

Next up, we have the consolidation or ranging phase. This is a reversal phase that doesn’t even always happen (e.g. in spike reversals, it will be very short or non-existent), but mostly will be there in some form. Here is where we will see specific reversal chart patterns such as double/triple tops or head and shoulders. In the phases example above, the reversal pattern is a double (or even triple) top, which I have marked with red arrows.

 

This is a stage that is often defined by very volatile behaviour, lots of ups and downs. It makes sense if you think about it: this is the area where the buyers and sellers are battling it out! Assuming we just had an uptrend, the buyers will want to see the uptrend continue and early sellers will want to see the price move down. There will be some profit taking by buyers, pushing the price down some more. Additionally, some buyers will see this as a retracement of the trend and will add to their position or enter the market long. This phase is like a tug of war between buyers and sellers, a lot is happening here!

 

rope pulling ranging market

 

The title says ranging phase, but there won’t always be a very well-defined range. If we have a head and shoulders, one side of the range will often be marked with just a single touch of the head. Meanwhile, a neckline starts to appear, which is often the opposite side of the range.

 

I will be looking for three things in the ranging/consolidation phase:

 

Reversal patterns: this is where the reversal chart patterns should be happening. My favourite patterns will be a head and shoulders, double or triple top/bottom and a rounding top/bottom. Although wedges are also considered a reversal pattern, I prefer other patterns to trade.

 

head and shoulders and double bottom

 

 

Buyer/Seller shift: I will be closely monitoring the candles here. Are they predominantly bullish or bearish? Small candles or strong, big ones? Lots of spikes or is the market agreeing about the direction? What I want to know here is mainly this: can we deduce a common market direction from this phase? Is it mainly going down or going up? Who is in control?

 

buyers vs sellers in control

 

In the example above, we can clearly see that sellers were first in control. Continued bearish candles with no to very little bullish pushback. At the bottom, however, things changed. We can suddenly see that there are many more green candles than red ones, and the green candles are also much larger in size. This indicates that a shift between buyers and sellers has taken place. This is an important clue to observe during the consolidation/ranging phase.

 

 

A transition phase with a range breakout: see below!

 

 

2.1 Transition Phase: Range breakout

 

I want to have an interlude for the range breakout. In the original reversal phase image, do you see that small blue rectangle with the candle marked with an arrow? This candle shows us a lot of bearish momentum and breaks through the lower bounds of the range.

 

This is an example of what I’m looking for as an entry trigger (such as the pin and drive). Other entry triggers would be engulfing bars or generally bars with a high momentum in the direction I want to trade.

 

Often, this range breakout will happen in the latter part of a reversal process in a way that, if you could divide the phases chart in two, I’d be looking for entries in the second part of the chart:

 

Trend reversal phases divided in two

 

If you use a moving average (I’m using the 20-period simple moving average here), you will often notice that in this transition phase, the moving average will already be going down. This is another indicator that we’re at the beginning of a new trend and we have, indeed, found a trend reversal.

 

 

3. Reversal Trend Phase

 

This is the final phase. This is where you probably should be in a trade already or looking to enter on a high momentum candle. And I have to disappoint you, but this doesn’t even always happen! Many times, trends will transition into a ranging market and keep on hovering inside a range. This range might then even break out in the direction of the initial trend, in which case we will have a trend continuation instead of a reversal. But let’s just assume we had a breakout to the “right” side and the reversal is taking place.

 

Often, we will see a speed-up of the price action in the direction of the new trend. This is because more and more traders are discovering this new trend and want to get on board. Additionally, many traders who thought this was a temporary retracement will have their stop losses hit, which will also accelerate the new trend.

 

In this phase, you should be looking at potential zones where the price might find support or resistance, in order to take (partial) profits at those levels. If you’ve gone through all of the phases described above: congratulations! You’ve successfully traded a trend reversal!

 

 

Reversals and Trend Strength

 

Now that we have looked at the different phases of a reversal, I’d like to take a moment to go over the initial trend and how you can know that the trend strength is decreasing. After all, if a trend is losing steam, it could be the first signal that a reversal might be coming up.  There are a few ways to do this and after years of trading, it’s become almost second nature for me to see this in an instant but these ways to detect trend strength are still very useful.

 

 

1. Moving Average Slope

 

Using a moving average is a good way to see where the price is, relative to the overall trend. One popular filter in trade setups is to look if the price is above or below a moving average and only take a trade in that direction. However, the moving average can also be used to see if a trend is losing steam, by looking at the slope. The steeper the slope of the moving average, the more likely that this trend is not yet over. On the other hand, if the moving average slope is flattening out, we might start to look for reversal patterns.

 

Here’s an example of three distinct phases in an uptrend, with the accompanying slope and angle:

 

Trend angle

 

As you can see from the chart, we first go from a slope of more than 60º to an intermediate slope of around 40º to an almost-flat slope of 10º. This flattening of the slope tells you very valuable information about the strength of the trend.

 

 

2. RSI Divergence

 

Most traders use the RSI indicator in a traditional way: look for short opportunities when RSI exceeds 70 and look for long opportunities when the RSI goes below 30. In my experience, the fact that the RSI crosses these values is hardly ever a reliable trigger to enter a trade, but it does indeed give us a clue as to how long a trend has been going on.

 

Another way to use the RSI indicator and how I use it is by measuring divergences. That is, I look for moments where the price trend is still going in one direction and the RSI trend is already going in the opposite direction. Let’s clarify this with an example:

 

RSI divergence

 

Here, we can see that the price is still making higher highs, while the RSI indicator trend shows us lower highs. When this divergence occurs, it’s another signal that the current trend is losing strength and a reversal might be impending.

 

Of course, RSI divergence also works in the other direction:

 

Bullish RSI divergence

 

 

3. Bullish vs Bearish Bar Analysis

 

Finally, the candlesticks themselves will often give you a clue on how strong a trend is. For this, I look at two things:

  • the ratio of bullish bars vs bearish bars
  • the strength of bullish and bearish bars, relative to each other

 

Again, this is best explained with an example:

 

Bearish vs bullish candles ratio

 

 

Please note that there are other tools and indicators to do this, but I’ve found that the three above are sufficient to gauge trend strength and there’s no need to complicate it any further with other tools.

 

 

Reversal FOMO

 

Everyone starting out with trading reversals seems to suffer from reversal FOMO (fear of missing out). This is what usually happens:

 

Reversal fomo

 

The moment price goes up, new traders think that the reversal has started and buy. Then they get stopped out. A little annoyed, they try again. After all, this looks like a stronger move than before, no? Still stopped out. Completely discouraged, the trader will stop looking at the charts or ignore the final signal that breaks the resistance of all the previous breakout attempts.

 

Then, this happens:

 

Reversal fomo 2

 

How to make sure this doesn’t happen to you? I have three ways of determining if you should take a reversal entry or not:

 

 

1. Swing High / Low Analysis

 

Look at the trend waves in the example above. In the first entry two attempts, the price is still making lower highs and lower lows. If this is the case, the reversal might just be a temporary pause in the current trend and resume in the same direction.

 

On the other hand, look at the last example. The price failed to make a lower low and the strong bullish candle made a higher high. This gives us a very good clue that a new trend is in the making and we indeed have a reversal.

 

Here’s another example of swing points in a reversal and how suddenly, there is a shift from higher highs and higher lows to lower highs and lower lows:

 

Reversal high low analysis

 

 

2. Break of Local Support / Resistance

 

Preferably, we want to see a break of the local support (for bearish reversals) or resistance (for bullish reversals). If that hasn’t happened yet, there’s a fair chance that the price will run into this support/resistance and bounce off it. Have a look at the chart below:

 

Reversal local resistance break

 

For the first two entries, the previous highs weren’t broken and the price kept moving lower. It’s only with the third entry that both of the local highs created by the first two failed entries are broken. This indicates that the price has the strength to push higher, which brings us to the third point.

 

 

3. Momentum

 

You see how the candle for entry 3 is much stronger than every other candle before? It manages to push through multiple resistance levels and shows strength to push higher. Momentum is a good indication if a move will have the potential to continue in the same direction. Specifically, I will be looking at candles that are much larger than the candles preceding it and with a close that is near to the high of the candle.

 

 

If we combine the three criteria above, it means we are looking for higher highs and higher lows (in a bullish reversal), breaking previous resistance or a range boundary with momentum. If these things happen at the same time, you will be less likely to enter too early and be stopped out on what otherwise may be a perfectly good reversal setup, just because you entered too soon.

 

 

 

Reversal Patterns

 

With the above out of the way, I’d like to discuss the reversal patterns I prefer trading. These are by no means the only reversal patterns, just the ones I find the most useful and reliable in my own trading.

 

Rounding top and rounding bottom

 

These are probably my favourite type of reversal to trade. They’re quite easy to spot and offer plenty of opportunities to get in, whatever entry method you use. They are characterised by a slow and gradual flattening of the trend. This then rolls over into a new trend in the opposite direction.

 

It is usually not too hard to spot the three distinct phases of a rounding top or rounding bottom reversal, which makes trading this pattern relatively easy: you just wait for a break of the range boundaries with a high momentum candle.

 

See in the following example if you can detect where I would’ve gone in on this trade:

 

 

Rounding top reversal

 

Here’s the same chart, this time with the markup on a good entry point. Notice that the candle that breaks out the range is high-momentum. This means that relative to the other candles, this candle is large and closes near to its low price:

 

Rounding top reversal with markup

 

 

Double Top and Double Bottom

 

The double top and double bottom reversal pattern will often seem similar to a rounding top or rounding bottom and indeed, they’re often alike. The double top and double bottom, however, can have more defined peaks which make it not really “rounding”.

 

With double top and double bottom reversals, there will be a neckline: a line or zone that connects the left side of the pattern with the right side of the pattern, while touching the “nose” (the middle of a double top/bottom pattern). Double tops and double bottoms form the basis of the WhaM trading strategy and they’re usually very reliable patterns.

 

Double top trend reversal pattern

 

Trading this pattern is relatively similar to the rounding top or rounding bottom pattern: you define the neckline (see the red rectangle in the chart above) and wait for a strong break of that neckline. The ranging phase of this reversal is defined by this double top/bottom pattern with the neckline as the lower bound of the range.

 

Keep in mind that not every double top or double bottom will look picture-perfect. Sometimes, one of the tops will be slightly higher than the other or sometimes, the neckline won’t be perfectly horizontal. There are many different variations of reversal patterns and often, they don’t look as textbook as the example above. It takes practice to find the patterns and see which ones work reliable and which ones don’t. This experience comes with time, so give it a while to learn about these patterns.

 

 

Head and Shoulders

 

Finally, my favourite trend reversal pattern! Head and shoulders happen quite regularly and they’re reliable patterns as well. Their reliability stems from the fact that they embody the foundation of a reversal: rejection of a price level and the transition from higher highs to lower highs (in an uptrend) or from lower lows to higher lows (in a downtrend).

 

Head and shoulders patterns are defined by a high (the left shoulder) followed by a higher high (the head) and then a lower high (the right shoulder). Of course, inverted head and shoulders patterns are just as valid; in this case, we will be looking for a low (the left shoulder) followed by a lower low (the head) and then a higher low (the right shoulder).

 

Head and shoulders trend reversal pattern

 

The classic way to trade this pattern is to wait for a break of the neckline – the line that connects the base of the pattern. In that sense, it’s very similar to a double top or double bottom. An alternative way to trade this pattern is to wait until the high of the right shoulder is formed and get in as soon as we see some momentum in the direction of the new trend. This will potentially give you a better risk to reward ratio, but the drawback is that you will have more losing trades as the pattern isn’t confirmed yet at this point.

 

Again, the patterns won’t always be a textbook copy. This could also be considered a head and shoulders pattern with a sloped neckline:

 

Head and shoulders alternative

 

 

Conclusion

 

In a world where a lot of traders employ trend-following strategies, trading trend reversals may sound like the complete opposite to do! However, if you think of it, what trend reversal traders do is not finding the tops and bottoms of a trend. Instead, reversal traders look at the cues that precede a new trend. In that way, reversal traders are actually early trend traders, infused with a bit of momentum trading once a reversal breakout happens.

 

We can divide reversals into two broad categories: sharp reversals and gradual reversals. I prefer the second category as they’re easier to trade. Every reversal is composed of multiple phases: the early trending phase, the ranging and consolidation phase and the reversal trend phase. Being able to detect the distinct phases will help you analyse a potential reversal and make the right decisions on when to enter a reversal trade.

 

In order to spot a reversal, we can look at multiple cues: trend strength and exhaustion, the slope of the trend and distribution of bearish vs bullish bars. It’s important to be patient to jump in, however, as we want to trade a reversal that has already been going in the new trend direction. Never stand in front of a moving train and don’t try to catch tops and bottoms!

 

Finally, there are multiple trend reversal chart patterns that make it easier for reversal traders to make sense of a reversal: rounding tops and rounding bottoms, double tops and double bottoms and (inverted) head and shoulders. There are other patterns, but these three are tried and tested and will get you started with trading trend reversals in no time!

 

 

Have you tried trading trend reversals yet? Or maybe you need some help with trading reversals? Let me know in the comments!

 

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Felix

I'm a full-time, independent forex trader. I've been trading for over 10 years and specialise in reversal trading, trading psychology, algorithmic trading and coaching others. When I'm not trading, I'll either be travelling the world or rock climbing (likely both). Read my story here.

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  • Chris M.

    Thank you for sharing Felix. It’s helpful for me to read your strategy and compare to how I have been trading. I like to trade reversals and I think I have developed a good eye to catch them, but I tend to jump too early (ie. try to catch the very top/bottom).
    Seeing how you trade, which is waiting for the new trend to actually start, seems to be a good way forward for me to secure safer entries. I’m interested in where you would place your stops in these situations too. Thanks for sharing your work!

    • Hi Chris, most traders will try to catch tops and bottoms, because that’s the more exciting thing to do. It won’t work 4 out of 5 times, but the one time it does, that’s the one time they’ll remember 😉

      As for stop placement, I will always look for a logical place to put them. If the momentum candle is relatively large, a good spot is often a bit above/below that one. If it’s too small, try to find previous swing highs/lows, look at price structure. If that candle is too big, I will look at the breakout zone I often indicate on my charts and put the stop loss a bit above/below that.

      There’s definitely no single best answer, but instead of looking at things like fixed SL or ATR-based SL, I’ve found that it works best if you just look at what price structure and find a stop that, if the price retraces to that level, your original trading idea would be invalidated.

      • Chris M.

        Thanks for the reply Felix, I will be looking to identify breakout zones after the reversal and label the trades where I use this style of entry to track it’s performance. I have felt safer placing a stop above the price (ie. trying to pick tops/bottoms), rather than placing one where it has already been (as in the breakout scenario), however it looks like the breakout phase will produce higher win rate. Thanks!

  • Tamás

    Felix, do you have some rule for the breakouts, e.g. how many pips and/or how much time after the breakout you enter, because I too often fail with breakouts.

    • A fixed number of pips doesn’t work as some pairs are more volatile than others. Instead, I will look at the breakout candle in the context of the rest of the price action. It has to stand out a bit and show that momentum is on our side, instead of just being another small candle.

      If I enter, it will be at the close of the breakout candle. So let’s say you watch the 4H charts, then after the breakout candle closes and a new 4H candle is created, that’s usually where I would enter a position.