Reversal Trading Strategies

Reversal Trading is a strategy that involves spotting when the market trend might flip directions. In this article, we'll explore how to identify several Reversal Trading strategy patterns with help from Technical Indicators, where to set your Entry Points, Stop Losses, and Targets in your trading strategy, backed by clear examples and screenshots from our trading platform. By the end, you’ll recognize and use these Reversal Trading patterns to potentially enhance your trading strategy.

What is Reversal Trading?

Reversal Trading is a strategy for identifying when a market might reverse. This strategy is crucial for traders looking to capitalize on shifts from rising to falling markets or vice versa. Understanding Reversal Trading strategies involves recognizing specific patterns and signals that suggest a trend is nearing its end. Below, we’ll explore how to spot these turning points effectively and the common hints that indicate a potential Reversal, helping you make more informed trading strategy decisions.

1) Head and ShouldersPattern

The Head and Shoulders pattern is a well-known Reversal signal in a trading strategy that a current trend might soon reverse. This Reversal Trading pattern appears as three peaks on a chart, where the middle one (the head) is higher than the two side ones (the shoulders).

Entry Point

The moment you enter the market is critical in a trading strategy – particularly when the Head and Shoulders Reversal pattern has fully developed. This pattern consists of three parts: the left shoulder (the price climbs higher than the first peak), the head (price rises higher than the first peak), and the right shoulder (lower than the head, same as the left shoulder).

For a regular Head and Shoulders Reversal pattern (indicating a downtrend): Wait until the price drops below this neckline after forming the right shoulder. This drop signals that the existing uptrend may reverse, and it’s a good time to consider selling.

For an inverse Head and Shoulders Reversal pattern (indicating an uptrend): Watch for the price to rise above the neckline after the right shoulder forms. This rise suggests the downtrend is reversing, making it a potential buying time.

Stop Loss

For a regular Head and Shoulders Reversal pattern, place your Stop Loss above the right shoulder in trading. If the price climbs above this level, the expected downtrend Reversal might not materialize, and the pattern could fail in trading. Placing the Stop Loss here helps limit potential losses by exiting the trade if the Reversal does not occur as anticipated.

For an inverse Head and Shoulders Reversal pattern, set your Stop Loss below the right shoulder. If the price drops below this point, it indicates that the anticipated uptrend Reversal may not unfold, signaling a failure of the pattern. Setting your Stop Loss at this level ensures you exit the trade to avoid larger losses if the market direction continues downward.

Target

To set your Target for a Reversal in trading, do the following:

For a regular Head and Shoulders Reversal pattern, measure downward from the neckline following a break below it. This projects a potential downward trajectory equal to the pattern’s height, indicating how far the price might fall.

For an inverse Head and Shoulders Reversal Trading pattern, measure upward from the neckline after the price breaks above it. This projects an upward trajectory equal to the pattern height, suggesting how high the price might rise.

2) Double Top and Double Bottom

Double Top and Double Bottom patterns are significant in trading strategies, appearing after a strong price movement-up or down-and suggest that this trend is losing strength.

A Double Top happens when prices rise to a high point, drop slightly, and then rise to that high point again before falling more significantly. This Reversal Trading pattern indicates that the market might start to move downward.

On the other hand, a Double Bottom occurs when prices drop to a low, rise again, and then drop to the same low before climbing more noticeably. This suggests that the market could move upward.

Entry Point

For the Double Top pattern, the Entry Point typically occurs after forming the second peak. You should look to enter a trade when the price falls below the support level-the lowest point between the two peaks. This drop below the support level signals that the uptrend is losing momentum, and a potential downtrend may begin. Entering a trade at this point allows you to capitalize on the expected downward movement.

For the Double Bottom pattern, the ideal Entry Point comes after the second trough has been formed. Consider entering a trade when the price breaks above the resistance level-the highest point between the two troughs. This break above the resistance indicates that the downtrend is weakening, and an upward trend is likely starting. By entering a trade here, you can take advantage of the anticipated upward movement.

Stop Loss

For the Double Top pattern, place your Stop Loss above the second peak. This positioning is strategic because if the price rises above this level after you've entered a short position (expecting the price to fall), it could indicate that the expected downward Reversal might not occur. The Stop Loss above the second peak minimizes your losses by automatically closing the trade if the downtrend fails to materialize.

For the Double Bottom pattern, set your Stop Loss below the second trough. If the price drops below this point after you've entered a long position (anticipating a rise), the market may not reverse upwards as predicted. Placing the Stop Loss here helps protect against larger losses by exiting the trade if the anticipated upward trend does not proceed.

Target

For the Double Top pattern, the Target is typically set by measuring the vertical distance from the top peak to the baseline (the lowest point between the two peaks) and then projecting this distance downward from the baseline. This method provides a quantitative goal and helps gauge where the price will likely fall following the pattern's completion. Entering a trade after the price breaks below the baseline, your Target placement helps ensure that you exit the position at a point likely to maximize potential gains before the market potentially levels out or reverses.

For the Double Bottom pattern, set your Target by measuring the distance from the bottom trough to the baseline (the highest point between the two troughs) and then projecting this distance upward from the baseline. This measurement provides a clear exit point for when the price is expected to rise following the pattern's confirmation. By setting your Target above the baseline where the breakout occurs, you can capitalize on the upward momentum, securing potential profits at an anticipated peak in price movement.

3) Fibonacci Retracement

The Fibonacci Retracement levels are used in this trading strategy to predict where prices might pause or reverse. This method involves using specific percentages-23.6%, 38.2%, 50%, 61.8%, and 78.6%-known as Fibonacci strategy ratios. Traders apply these ratios to a price move to determine potential support or resistance levels. These are points on the chart where prices might stop falling or rising and possibly change direction.

Entry Point

Closely monitor how prices behave near key Fibonacci strategy levels-specific percentages of a prior price movement that often act as support or resistance. Watch for price action signals, such as candlestick patterns that form near these Fibonacci levels.

Similarly, if the price rises and then a bearish Reversal candlestick pattern (such as a shooting star or bearish engulfing) forms at a Fibonacci level, it might be a good opportunity to enter a sell trade, anticipating that the price will start to fall.

Stop Loss

Place your Stop Loss beyond your entry point’s next Fibonacci strategy level. This trading strategy gives your trade enough room to breathe. It provides a clear boundary to cut losses if the Reversal doesn’t go as planned.

Target

Use Fibonacci strategy extension levels or previous support/resistance levels to effectively guide where to set clear Targets for taking potential profits.

Common Fibonacci extensions are 161.8%, 261.8%, and 423.6%. If you decide to enter a trade when the price retraces to the 61.8% Fibonacci level, you can set your potential profit Target at one of these extension levels.

Previous Support/Resistance Levels indicate where the price has historically found support or resistance and reversed. By setting Targets near these levels, you're aligning your trading strategy with tested market behaviors, which can increase the likelihood of hitting your Target before the price reverses.

4) RSI Divergence

For traders focused on Reversal Trading Strategies, spotting Relative Strength Index (RSI) divergences is essential. These divergences are powerful Momentum Indicators providing key signals that a market trend may weaken and is set for a Reversal. This occurs when the Relative Strength Index (RSI) does not align with the asset’s price direction. Specifically, if the asset’s price hits a new high or low but the RSI fails to follow suit and moves in the opposite direction, it suggests a loss of momentum in the current trend.

Entry Point

Look for a situation in your strategy where the price of an asset makes a new high but the RSI indicator does not. While the price increases, the momentum behind the price movement decreases. This mismatch is known as divergence and can signal that the price might soon start to fall.

Stop Loss

Place a Stop Loss beyond the recent high/low.

For example, in a bearish Reversal Trading strategy signaled by RSI Divergence - where the price makes a higher high while the RSI makes a lower high - you would set your Stop Loss above the recent high reached by the price. If the expected downward trend does not materialize and the price rises, your position will be closed at a predefined point, thus limiting your losses.

Target

Use previous support/resistance levels or a risk-reward ratio to set Targets.

In a bearish Reversal scenario, where you enter a sell trade because the price makes a higher high but the RSI indicates a lower high, your Target should be set where you anticipate the price will drop to before potentially reversing again or leveling out. A practical approach is to identify previous support levels on the chart. The price has historically stopped falling and started to bounce back up in these areas.

5) Moving Average Crossover

The Moving Average Crossover, essential in both Reversal and Momentum Trading, tracks price trends using two lines: a short-term and a long-term moving average. When these two lines cross, it can signal a shift in the market.

If the short-term line crosses below the long-term line, it's a hint that prices might start falling, indicating a bearish (downward) Reversal. On the other hand, if the short-term line crosses above the long-term line, prices may rise, signaling a bullish (upward) Reversal.

Entry Point

Enter the trade when the crossover occurs: when the short-term Moving Average crosses above the long-term average, it signals a potential bullish market turn, suggesting it's a good time to enter a buy trade. Conversely, if the short-term average crosses below the long-term average, it indicates a bearish turn, making it an opportune moment to enter a sell trade.

Stop Loss

If you enter a buy trade (when the short-term Moving Average crosses above the long-term average), you should place your Stop Loss below the most recent swing low. This protects you from losing too much if the price unexpectedly drops.

For a sell trade (when the short-term Moving Average crosses below the long-term average), set your Stop Loss above the most recent swing high. If the price suddenly rises, your potential losses are minimized.

Target

Use previous support/resistance levels or a risk-reward ratio to set Targets:

Using Previous Support/Resistance Levels: When the short-term Moving Average crosses above the long-term average indicating a potential buy, look at historical data to find where prices have previously struggled to rise above (resistance) or dropped below (support). Set your Target near these levels, as they are likely points where the price might stall or reverse again.

Using a Risk-Reward Ratio: Another method is to use a risk-reward ratio, which helps manage how much risk you're taking compared to the potential reward. A common ratio is 2:1; for every dollar you risk, you aim to make two. For instance, if your Stop Loss is set $10 below your entry price, you might set your Target $20 above your entry price.

Conclusion

The Reversal Trading strategy requires careful observation and strategy refinement. Keep practicing and staying informed about market trends to improve your trading strategy and its outcomes. At easyMarkets, we are dedicated to equipping you with the essential knowledge for successful trading, helping you navigate market Reversals more effectively.

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