Hi there Forex Traders!
Today’s article is focused on anticipating trend reversals in forex. When could Forex traders expect a trend to end? What signs are visible and looming on the horizon when the trend is losing steam? We will take a look into this through the framework of trends, reversal trading, and the impact of reversal signals.
To refer back to this quote from Bill Williams: "Go with the flow, ride the tide, bend with the trend." The articles of the previous 2 Friday’s have both discussed trends and discuss the go with the flow and ride the tide part of the quote. First of all, it explained the importance of a trend and defining a trend, and then dived into tools and methods of trend definition. You can find more in our Best Average Range Forex article.
Framework of trends
With this and next’s week article we will finish the entire spectrum of environments:
1) Trending environments
2) Counter trend environments
3) Lack of trend/range environments
This together with the articles on entry methodology and nature of the Forex market (impulse versus correction and chart patterns) should give you a great starting/advanced guide of how to trade in the Forex market successfully.
And as a proof of evidence, we implement our specific trending strategy ourselves and made the following past trades: GNPZD +2.5, NZDJPY +2, GBPJPY, +0.3, EURJPY 0, AUDJPY 0, USDJPY -1, CADJPY -1 for +2.8 total this week.
Other trade calls, which were not taken by WET account due to normal risk management parameters, were GBPUSD +2, GBPCHF +2, EURNZD +1.7, AUDJPY +2, NZDUSD +1.3, AUDNZD 0, NZDUSD 0, CADJPY 0 (excluding the 6 trade calls that all went for +2 during FOMC). Take a look here at our trading room for more details.
Once the Forex market is a trend, the end will one day unfold and the trend will stop. But how will it stop and when? Will it make a small pullback or a big retracement, or will the currency pair make a reversal in fact? These questions are difficult to answer and that is why with the trend trading has higher statistical odds of success. And that is why when trading trend reversals, the Forex trader needs to have a trend reversal trading strategy to offset the lower odds of trading success with higher reward to risk ratios in order to retain and remain profitable (unless a trader has a proven method which allows for lower r:r).
When and how to identify trend reversal in forex:
Trading trend reversals are usually speaking only recommended for traders with at least 5 years of Forex trading experience, and sometimes 7-10+ years. Until then, focusing on with the trend setups is the basic premise and the reason is simple: trading with the trend is already tough enough. 😉 First trend trading needs to be mastered.
Focusing on the trend trades is NOT as easy as it might seem. Why? Many Forex traders want to be in a trade right now and right here and trade the Forex regardless of whether the market is set up sufficiently for their edge to materialize. Missing a trade is often unbearable for a trader, but chasing the market is hazardous for the equity curve and profitability. Other potential reasons for that could be a lack of trust in the trend and the attractiveness of picking a top or bottom. However, the middle 60-80% of the trend is the real juicy part traders should be targeting.
Trading with the trend requires a balanced dose of patience, discipline, trust, and confidence. Keeping one’s mindset focused on with the trend trades is already an accomplishment in itself, because most of the time it is oh-so-easy for the trader to wonder with their creativity and seek out trades that are in fact reversal trade setups.
Impact of Reversal Signals
Watching out for reversal signals always makes sense. Regardless of the fact if you are with the trend trader or reversal trader, or both, watching out for reversal signs is a very important part of trading. Reversal traders use these signals to establish their entries. With-the-trend traders use these signals to exit their trades and/or refrain from trading with the trend. By keeping an eye on the reversal signals, the with-the-trend trader becomes a smart trend trader.
Reversal signals could have various impacts such as:
1) Passive retracement - price goes sideways and corrects trend in time.
- Usually a chart pattern such as a flag or triangle.
- This retracement is shallow à corrective price action.
- If the sideways move takes too long in time, then it will become a range (point 4).
2) Active retracement - price moves in a counter-trend direction and corrects trend by pips.
- This retracement can vary in depth depending on the timeframe.
- A retracement on the higher time frame would be deeper.
- This retracement is more impulsive in nature.
3) Reversal - trend direction changes from up to down OR down to up.
4) Range - one trend stops and is followed by a range environment.
Also, the importance of multiple time frame analysis is back into play. Here is why:
A.) Reversal signals on a higher time frame command more respect from the market participants than from lower time frames.
B.) Multiple reversal signals on 1-time frame give more confluence and increase the odds of the signals indeed having an effect.
C.) Multiple reversal signals on multiple time frames also increase the odds of those signals having an effect on the price.
Important warning: reversal signals and chart patterns take time to play out and develop and usually do not materialize immediately.
Potential reversal signals can vary widely. We will discuss my methods and also look at a few other commonly used techniques to tackle this topic.
1) Divergence. This method is often the number one on the reversal signals list and so it should be. The trend is your friend and it will remain so until the trend becomes unsustainable. The latter happens when the trend is not supported with sufficient momentum. If the price is making higher highs and higher lows, but the oscillator is not confirming price action with equivalent higher highs, then the probability of trend continuation is decreasing. This means 1 of the above scenarios (passive or active retracement, range or reversal) is imminent. In the case of a retracement, the trend can and will continue. Obviously, the trend ends when a range or reversal kicks in. More on trading divergence here.
2) Candlestick reversal patterns. Candlesticks are great indications when a move would have higher statistical odds of ending. A pin bar or engulfing twins are candlesticks which indicate that the with-the-trend move is losing its momentum.
3) Support and resistance such as Fibonacci retracement / tops & bottoms / trend lines / moving averages / Fibonacci targets / Fibonacci extension. When in a trend, it is important to keep an eye out for obstacles that could hinder a trade from developing. In an uptrend, a Forex trader wants to check whether a resistance level (such as the ones mentioned above) could be blocking the trade from developing (opposite is true for the downtrend). The most important resistances are always on 1 and 2 time frames higher than your usual chart viewing time frame.
4) Chart patterns. Head and shoulders, inverse head and shoulders, rising wedges, falling wedges, double top, double bottom, triple top, and triple bottom are all examples of chart patterns that indicate a lack of trend continuation probability. The confirmation of the pattern completion is the break of the neckline.
5) Weakness: Lower highs and higher lows. A trend is confirmed when it keeps posting lower lows and higher highs. If a trend cannot break resistance or support and price forms lower high or higher low, then the steam of the trend might be slowing down. Be careful, as the trend could only be encountering a small hiccup before continuation, especially if this happens in a trend channel. The lower high or higher low could in some cases be a pattern as mentioned above as well.
6) Break of trend lines and trend channels. An important signal and confirmation of a trend ending is the break of the trend channel. The break of the trend channel or line is not an immediate indication of a reversal, however, as the currency could also become a range (using the top or bottom as support and resistance). It just shows that the past trend has been placed in the fridge for now (end of trend), and the trader needs to be cautious or even refrain (depending on the strategy preference and trader) from trading until more evidence supports the ideal trading environment of the Forex trader.
7) Break of the bottom or top. The break of the bottom or top indicates that a range formation is less likely and that the chances of a reversal occurring are increasing.
8) Nature of price action. Price will move either impulsive or corrective. Knowing which is which will help understand the momentum dynamics of the market structure. An important aspect to realize is that the market can make impulsive corrections (moves with momentum against the trend), and corrective impulses (moves a with little momentum with the trend) as well, although the opposite is most common and likely.
9) Elliott Wave counts. By counting the waves and the waves within waves (sub waves), a Forex trader can increase their understanding of the market structure and provide more accurate weight to certain scenarios or paths of least resistance.
10) Time factor. Depending on how long a move takes to develop, the likelihood of a trend continuation is decreasing. If the with-the-trend move occurs too quickly, then there is a higher statistical probability of a retrace. If the with-the-trend move occurs too slowly, then a with-the-trend move has less statistical chances of occurring and the odds of reversal or range environment are higher.
11) Other elements: Ichimoku cloud, oscillator peaks, oscillator crossovers, price breaking through moving averages, Gann angles, Gartley patterns, bands, Bollinger bands, candle highs/lows, etc. Here is an example of master candle setup.
What elements do you use for identifying the end of trend signals? Did this article help you? Let us know down below in the comment section. Please leave a comment below if you have any questions about Trend Reversals!
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Thanks and Good Trading!