Mastering Reversal Trading in Forex

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Contributor, Benzinga
May 10, 2023

For forex traders looking to add strategies to their arsenal, learning about market reversal trading can provide yet another way to capitalize on market moves. 

Reversal trading involves the recognition and anticipation of a shift in a market trend, which can result in sizable returns when such reversals are properly traded upon.

In this guide, Benzinga will cover the basics of reversal trading, including a breakdown of how reversal patterns work, the basic rules and principles to apply when trading market reversals and some helpful tips for managing risk when doing so.

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What Is Market Reversal Trading?

Market reversal trading is a form of technical analysis used by traders of many asset markets, including currency pairs, to identify and capitalize on potential market turning points and retracement phases. Reversal trading is ideal for short-term and swing traders looking to benefit from relatively short-term fluctuations in the forex market, so it has become a popular strategy used by many forex traders. 

Market reversal trading involves first looking for chart formations and confirming technical indicators that suggest a potential reversal of the overall trend is likely. This price action trading method then looks for suitable entry points to take advantage of the anticipated sudden shift in market direction against the prevailing trend. 

Although reversal trading can be difficult to master, understanding the core concepts and techniques of reversal trading can help currency traders maximize their profits and minimize their risks. 

How Does Reversal Trading Work?

The basic idea in reversal trading is to take advantage of market swings with the goal of buying low and selling high. To successfully trade a trend reversal in this way, traders must remain nimble and be able to recognize and analyze technical signals as they appear in the market that point to an imminent reversal in its direction.

A key aspect of market reversal trading involves traders looking for signs of a weakened trend. They then make a calculated decision to trade in the opposite direction to the trend while managing their risk prudently in case the market moves against them. 

How to Implement Trend Reversal Trading

Understanding and identifying the market trend, watching for and recognizing market reversal patterns and relevant technical indicators and timing your trades well are essential elements of successful reversal trading. Techniques for taking these key steps are discussed below. 

Identifying the Trend of the Market

Before diving into how to actually implement trend reversal trading, it is important to understand how to identify the overall trend of the market. Identifying the trend and movement of the market is the critical first step to successfully implementing and managing reversal-based forex trading strategies since it helps traders to identify the direction of the market and position their trades accordingly. 

Spotting the trend requires identifying two key aspects: the trend’s general direction and the major high and low points that characterize it. Once these elements are established, the trend can then be used to identify potential reversal points. Several methods exist to identify the overall trend of the market that include the following three:

  1. Market action: You can analyze the historical exchange rates that have traded in the forex market to identify the direction of the market by looking at charts. An uptrend is identified by a series of higher highs and higher lows, while a downtrend is identified by a series of lower lows and lower highs.
  2. Moving averages: You can use moving averages to identify the direction of the trend. If the exchange rate of a currency pair lies above its moving average, then the trend is considered upward or bullish. Conversely, when its exchange rate is below its moving average, the trend is considered downward or bearish.
  3. Trendlines: You can draw trendlines connecting swing highs or lows to identify the overall direction of the trend. An uptrend is identified by an upward-sloping trendline, while a downtrend is identified by a downward-sloping trendline.

Once the overall trend of the market has been identified using one or more of the above methods, traders can use this information to trade market reversals more effectively. By understanding the overall trend of the market, traders can position themselves to profit from market reversals while minimizing their risk of losses.

For example, when the market is in an uptrend, traders can look for buying opportunities when the market experiences a temporary pullback. Conversely, traders can look for selling opportunities in a downtrend when the market experiences a temporary rally. 

Identifying the overall trend of the market using any of the established methods listed above is thus crucial when trading currencies based on trend reversals. Once you determine the direction of the trend, you can use this information to position for market reversals and minimize your risk of excessive losses.

Recognizing Market Reversal Patterns

Once the trend has been identified on an exchange rate chart, it is time to look for actual reversal chart patterns. Reversal patterns consist of various characteristics that when combined suggest a potential market reversal is likely. 

Market reversal chart patterns signal a potential change in the direction of the market trend and are widely used by traders to identify potential entry and exit points in the market. Such patterns usually provide traders with a clear trade entry point as well as an objective for taking profits once a breakout occurs and a stop loss level in case the trade fails. 

Traders looking to identify potential market reversals can take into account any of the classic reversal chart patterns or they can watch for candlestick patterns that indicate a reversal.  Each reversal pattern can suggest when an uptrend may reverse into a downtrend, or vice versa. Remember that confirmation of these patterns should be based on multiple indicators aligning before a trade is undertaken. 

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Some of the most popular market reversal chart patterns are pictured above and described in further detail below:

Double or Triple Top or Bottom 

The double or triple top is a bearish reversal pattern that forms when the exchange rate creates two or three peaks at approximately the same level. The double or triple bottom is a bullish reversal pattern and forms when the exchange rate creates two or three troughs at approximately the same level. 

A break out of these patterns is confirmed when the exchange rate breaks below or above the neckline level situated at the reaction lows or highs of the pattern. The profit-taking objective of the pattern is determined by calculating the difference between the top or bottom level and the neckline and then projecting that amount in the direction of the breakout from the breakout level. 

Head and Shoulders Top or Bottom

The top version of this classic pattern is a bearish reversal pattern that forms when the exchange rate creates three peaks, with the middle peak being the highest, that resemble the shape of a head and shoulders. 

To identify a head and shoulders bottom pattern, you need to look for three troughs with the middle trough or head being the lowest and a neckline that connects the two peaks on either side of the head. The head and shoulders pattern is confirmed when the exchange rate breaks through the pattern’s neckline. A breakout then sets up an objective calculated by taking the difference between the central peak or trough and the neckline and then projecting that distance from the breakout level in the direction of the breakout.

Rising or Falling Wedge 

The wedge pattern forms when the exchange rate moves in a narrowing range and forms a triangular shape with both converging trendlines sloping in the same direction. A falling wedge is a bullish reversal pattern, while a rising wedge is a bearish reversal pattern. These patterns are confirmed when the exchange rate breaks out of the wedge in the opposite direction to the preceding trend.

Expanding Triangle 

Also known as a broadening triangle or megaphone pattern, the expanding triangle occurs when a currency pair’s exchange rate is in a broadening triangular formation between two diverging trendlines that connect the highs and lows.  An expanding triangle pattern can be either bullish or bearish, depending on the direction of the trend leading up to the pattern.

If the previous trend was upwards, then a rising expanding triangle pattern is a bearish reversal pattern that indicates the exchange rate may reverse lower. If the prior trend was downwards, then a falling expanding triangle pattern is a bullish reversal pattern that suggests the exchange rate may reverse higher. 

Traders confirm expanding triangle pattern when the exchange rate breaks out of the pattern in the opposite direction of the previous trend. Note that expanding triangle patterns can be less reliable than other reversal chart patterns since the exchange rate is moving in an increasingly volatile manner because of growing uncertainty in the market. 

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Hammer/Shooting Star

These so-called “pin bar” patterns form on candlestick charts when the exchange rate data forms a long shadow and a small body that resembles a hammer or a shooting star. The hammer is a bullish reversal pattern, while the shooting star is a bearish reversal pattern.

To spot these patterns on a forex chart, traders need to look for the relevant chart formation and the key levels that confirm the pattern.

Similarly, for a double top/bottom pattern, traders should look for two peaks/troughs at approximately the same market level and a neckline level that connects the two lows/highs. A break of the neckline level should see the market move toward the pattern’s breakout objective.

In conclusion, traders use market reversal chart patterns to identify potential changes in the market trend. These patterns can be spotted on forex charts by looking for the relevant chart formation and key confirmation levels. By identifying these patterns, traders can position themselves to profit from market reversals while minimizing their risk of losses.

Timing Your Trading

Timing is important when trading market reversals because a reversal occurs when the market changes direction, shifting from an uptrend to a downtrend or vice versa. Forex traders who can identify market reversals early can profit from the resulting exchange rate movements. 

If the trader’s timing is off, however, they risk entering the market too soon or too late, which can result in missed opportunities or losses. Just because a reversal pattern is present, that does not necessarily mean that it is the right time to take the trade since it may take some time for the market to respond and for a breakout to occur. 

The best times to trade forex market reversals will depend on your trading strategy type and the currency pair being traded. For example, day traders may focus on intraday reversals and look for opportunities during the local opening hour of the forex market, while swing traders may analyze longer-term trends and look for reversals on weekly or monthly charts.

Here are some general guidelines for timing market reversals:

  • Look for key support and resistance levels that show where the exchange rate has previously bounced off and indicate a previous reversal point.
  • Watch for market confirmation and clear signs of a trend change, such as a trendline break or a series of lower highs or higher lows.
  • Use technical indicators like moving averages to identify trends and the Relative Strength Index (RSI) to measure market momentum that can help identify potential reversals by highlighting overbought or oversold market conditions.

To avoid losing money from false signals when trading market reversals, it makes sense to use multiple indicators and look for confirmation among them. For example, if a currency pair’s RSI indicates oversold conditions, you could look for an exchange rate move confirming an upside reversal before entering a long trade. Keep in mind that relevant news events and market sentiment can impact the forex market and cause false reversal signals. 

Managing Risk

Risk management should remain an essential part of your strategy for trading forex market reversals. Here are some strategies that you can use to manage risk, conserve your money and increase your chances of success when trading forex market reversals:

  • Use stop-loss orders: A stop-loss order automatically closes out a forex trade if the exchange rate moves against you beyond a certain point. You can use stop-loss orders to limit your potential losses in case the market reversal you anticipate does not materialize. 
  • Use proper position sizing: You should use prudent position sizing techniques to ensure you are not risking too much of your account balance on a single trade. A general rule of thumb is to risk no more than 1-2% of your account balance on any given trade.
  • Avoid excessive leverage: Using too high a leverage ratio when trading makes it harder to remain in business as a forex trader if you happen to experience a string of losses.   
  • Use trailing stops: You can use trailing stops to lock in profits at progressively better levels as a trade moves in your favor. A trailing stop is a stop-loss order that moves in specified increments along with the exchange rate. This method lets you capture more profits if the trade continues to move in your favor.
  • Take profits in stages: You can take profits in stages by closing out a portion of your market reversal trade as the exchange rate moves in your favor. This process can help lock in profits while still letting you benefit from further favorable market movements.
  • Use multiple timeframe analysis: You can use multiple timeframe analysis to get a better sense of the overall trend and potential reversal points. By analyzing the trend on multiple timeframes, you tend to get a more accurate picture of where the market may be headed and can make more informed trading decisions.

Currency traders need to learn how to manage their risk prudently since implementing good risk management techniques can make the difference between trading profitably or wiping out your account. Proper risk management is especially critical for market reversal trades since they can involve a higher degree of uncertainty and more volatile trading conditions when breakouts occur. 

Who Should Trade Market Reversals?

Mastering reversal trading requires patience, dedication and a thorough understanding of the concepts, patterns and strategies involved in doing so. With time and practice, many forex traders can develop their skills in market reversal trading and start earning profits from that sort of swing trading strategy. 

If you think market reversal trading sounds right for you, then keep firmly in mind that successful market reversal trading requires proper and timely analysis, risk management and the ability to identify potential reversal points in the market. 

Traders contemplating trading market reversals should also be prepared to experience losses and be disciplined enough to cut their losses when necessary because of the potential market volatility involved when chart pattern breakouts occur.

Frequently Asked Questions

Q

Is reversal trading profitable?

A

Market reversal trading can be profitable if executed properly, but it involves higher levels of risk and uncertainty compared to trading in the direction of the trend, and it requires skill, experience and a disciplined approach to trading.

Q

What causes a reversal in forex?

A

A forex market reversal is caused by a shift in the balance of supply and demand in the market for a currency pair. It can be prompted by a variety of influences, including technical factors and changes in economic data or political events that affect the market’s sentiment.

Q

How long does a reversal take?

A

The duration of a forex market reversal can vary widely depending on factors including the strength of the trend, underlying market conditions and what is driving the reversal. Some reversals may occur quickly and resolve within hours or days, while others may take weeks or even months to develop fully.

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About Jay and Julie Hawk

Jay and Julie Hawk are the married co-founders of TheFXperts, a provider of financial writing services particularly renowned for its coverage of forex-related topics. With over 40 years of collective trading expertise and more than 15 years of collaborative writing experience, the Hawks specialize in crafting insightful financial content on trading strategies, market analysis and online trading for a broad audience. While their prolific writing career includes seven books and contributions to numerous financial websites and newswires, much of their recent work was published at Benzinga.