Top Forex Reversal Patterns that Every Trader Should Know

Intraday reversals are often the result of news events and company announcements that change the valuation outlook for a specific stock.

In the case above, you see the Doji candle acting as a bearish reversal signal. 

Before we jump in on the bullish reversal action, however, we must confirm the upward trend by watching it closely for the next few days. Then you would want to hold the trade for at least the minimum price move equal to the size of the Shooting Star.

II. Sensitivity Test 

Forex reversal patterns are on chart candlestick formations of one or more candles or bigger chart patterns which forecast price reversals. Every chart pattern has a mass sentiment component that can help a trader in gauging potential price swings.

You jump in the car, head out on the open highway and soak in all of the scenery that you miss when you fly somewhere. Unfortunately, every road trip has to come to an end at some point, and you have to turn around and drive back home. Sometimes you turn straight around and head back immediately, but sometimes you delay heading home for just a little bit as you cruise around a little longer.

But either way, you end up turning around. They run into support or resistance levels and eventually turn around and start moving back in the opposite direction. Sometimes they turn around immediately, and sometimes they test the support or resistance level in front of them a few times before finally giving up and turning around.

Regardless, they eventually end up turning around. If the stock you are watching really is at the end of its road trip and is ready to turn around and head home, a reversal pattern will most likely form while the stock price consolidates. Reversal patterns tell you that the stock is going to turn around and reverse its previous trend after it breaks out of the reversal pattern.

Reversal patterns, like all price patterns, are made of the following four pieces: The only real difference you will see is in the shape of the consolidation zone. The consolidation zones of some reversal patterns have a single level of support and single level of resistance while others have multiple levels of support and multiple levels of resistance.

Every other aspect of the price pattern is identical. The following are the most common reversal patterns you will see during an uptrend: Double tops Head-and-Shoulders tops Double tops —double tops form during an uptrend as the up-trending stock price hits the same resistance level twice in the consolidation zone.

Triple tops —triple tops form during an uptrend as the up-trending stock price hits the same resistance level three times in the consolidation zone. Head-and-Shoulders tops —head-and-shoulders tops form during an uptrend as the up-trending stock price hits a lower resistance level, then hits a higher resistance level and then hits the lower resistance level a second time in the consolidation zone.

The following are the most common reversal patterns you will see during a downtrend: Double bottoms Head-and-Shoulders bottoms Double bottoms —double bottoms form during a downtrend as the down-trending stock price hits the same support level twice in the consolidation zone. In the first two cases, you have a bearish trend, which reverses to a bullish price move.

The difference between the two candles is that in the second case the long wick it positioned in the opposite direction and this formation is called an Inverted Hammer. In the second two cases we have a bullish trend which turns into a bearish trend. If the long shadow is at the lower end, you have a Hanging Man. If the long shadow is at the upper end, you have a Shooting Star. The chart above shows you a Shooting Star candle, which is part of the Hammer reversal family described earlier. The shooting star candle comes after a bullish trend and the long shadow is located at the upper end.

The shooting star pattern would signal the reversal of an existing bullish trend. Note that this is a double candle pattern. This means that the formation contains two candlesticks. The engulfing formation consists of an initial candle, which gets fully engulfed by the next immediate candle. This means that the body of the second candle should go above and below the body of the first candle. There are two types of Engulfing patterns — bullish and bearish.

The bullish Engulfing appears at the end of a bearish trend and it signals that the trend might get reversed to the upside.

The first candle of the bullish Engulfing should be bearish. The second candle, the engulfing candle, should be bullish and it should fully contain the body of the first candle. The characteristic of the bearish Engulfing pattern is exactly the opposite. It is located at the end of a bullish trend and it starts with a bullish candle, whose body gets fully engulfed by the next immediate bigger bearish candle.

Take a moment to check out this Engulfing reversal example below: This chart shows you how the bullish Engulfing reversal pattern works. See that in our case the two shadows of the first candle are almost fully contained by the body of the second candle.

This makes the pattern even stronger. We see on this chart that the price reverses and shoots up after the Bullish Engulfing setup. Trading Rules for Reversal Candle Formations To trade reversing candles, you should remember a few simple rules regarding trade entry, stop loss placement, and take profit.

We will go this in the following section: Trade Entry The confirmation of every reversal candle pattern we have discussed comes from the candle which appears next, after the formation. It should be in the direction we forecast. After this candle is finished, you can enter a trade. In the Bullish Engulfing example above, the confirmation comes with the smaller bullish candle, which appears after the pattern. You can enter a long trade at the moment this candle is finished.

This would be the more conservative approach and provide the best confirmation. Aggressive traders may consider entering a trade when the high of the prior bar is taken out in case of a bullish reversal pattern or when the low of the prior bar is taken out in case of a bearish reversal pattern.

Stop Loss Never enter a candlestick reversal trade without a stop loss order. You should place a stop order just beyond the recent swing level of the candle pattern you are trading. So, if you trade long, your stop should be below the lowest point of your pattern.

If you are going short, then the stop should be above the highest point of the pattern. Remember, this rule takes into consideration the shadows of the candles as well. Take Profit The minimum price move you should aim for when trading a candle reversal formation is equal to the size of the actual pattern itself. Take the low and the high of the pattern including the shadows and apply this distance starting from the end of the pattern. This would be the minimum target that you should forecast.

If after you reach that level, you may decide to stay in the trade for further profit and manage the trade using price action rules. The pattern consists of two tops on the price chart.

These tops are either located on the same resistance level, or the second top is a bit lower. The Double Top has its opposite, called the Double Bottom.

This pattern consists of two bottoms, which are either located on the same support level, or the second bottom is a bit higher. These patterns are known to reverse the price action in many cases. Notice we have a double top formation and that the second top is a bit lower than the fist top.

This is a usual occurrence with a valid Double Top Pattern. The confirmation of the Double Top reversal pattern comes at the moment when the price breaks the low between the two tops.

This level is marked with the blue line on the chart and it is called a trigger or a signal line. The stop loss order on a Double Top trade should be located right above the second top. The Double Top minimum target equals the distance between the neck and the central line, which connects the two tops. The Double Bottom looks and works absolutely the same way, but everything is upside down. Thus, the Double Bottom reverses bearish trends and should be traded in a bullish direction.

Head and Shoulders The Head and Shoulders pattern is a very interesting and unique reversal figure. The shape of the pattern is aptly named because it actually resembles a head with two shoulders.

The pattern forms during a bullish trend and creates a top — the first shoulder. After a correction, the price action creates a higher top — the head. After another correction, the price creates a third top, which is lower than the head — the second shoulder. So we have two shoulders and a head in the middle. Of course, the Head and Shoulders reversal pattern has its upside down equivalent, which turns bearish trends into bullish.

This pattern is referred to as an Inverted Head and Shoulders pattern. Now let me show you what the Head and Shoulders formation looks like on an actual chart: In the chart above we see price increasing just prior to the head and shoulders formation. This is an important characteristic of a valid head and shoulders pattern.

The confirmation of the pattern comes when the price breaks the line, which goes through the two bottoms on either side of the head. This line is called a Neck Line and it is marked in blue on our chart. When the price breaks the Neck Line, you get a reversal trading signal. This is when you would want to initiate a trade to the short side. You should put your stop loss order above the last shoulder of the pattern — the right shoulder.

Then you would trade for a minimum price move equal to the distance between the top of the head and the Neck Line.

The pattern comes after a bearish trend, creates the three bottoms as with a Head and Shoulders and reverses the trend. It should be traded in the bullish direction.

 

Bullish Confirmation 

The pattern does show strength, but is more likely a continuation at this point than a reversal pattern. The existence of a downtrend can be determined by using moving averages, peak/trough analysis or trend lines.

While a continuation pattern suggests that a trend in place will continue in the same direction after a brief pause/correction, a failed continuation pattern may well turn into a reversal pattern. Like their name implies, reversal patterns. These five popular candlestick chart patterns signal a bullish reversal in downtrend. 

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I. Trading Strategy

Technical analysts watch for reversal patterns throughout the day, because they can indicate the need for a different trading strategy on the same security or can provide an opportunity to profit. Forex reversal patterns are on chart candlestick formations of one or more candles or bigger chart patterns which forecast price reversals. Every chart pattern has a mass sentiment component that can help a trader in gauging potential price swings.

Reversal patterns tell you that the stock is going to turn around and reverse its previous trend after it breaks out of the reversal pattern. We discuss the specific elements that help you identify a true reversal pattern. (a) Reversal patterns are very sensitive to trading costs; (b) Reversal patterns with larger target exits are preferred. Related Entries: False Breakout (Setup & Exit 1) | False Breakout (Setup & Exit 2).

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