I always receive this question: How to spot trend reversal in forex? And here is the complete answer.
Identifying a trend reversal in forex is not an easy task. And will never be false proof. However, following consistent process to identify trend reversals will lead to good results.
Before outlining the methods, let’s have a very quick intro on trends.
Up and Down Trends
A trend is a directional price move that persists for a prolonged period. It can be an upside, or downside move.
An uptrend, in its general definition is a directional move to the upside that can be spotted visually. Technically, an uptrend should have a distinctive structure of consecutive waves, where each wave surpasses the prior wave.
An uptrend is a series of higher highs(peaks) and higher lows(troughs). Where each high surpasses the previous high, and each low is above or equal to the prior low. Each major upside wave is followed by a downside correction.
A Downtrend, also called a bearish trend is the exact opposite of an uptrend. It is a series of lower highs and lower lows. Where each low surpasses the previous low and each high is lower or equal to the prior high.
Forex Directional Trend Chart Example
Here is a real-life example of a Downtrend on NYMEX Crude Oil Daily Chart. This chart example is intended to help you identify the downtrend correctly (Same procedure goes for an uptrend).
It might look confusing at first sight, however, if you start reading the chart from the left-hand side and move with the price action it should make sense in no time.
If you start from the left-hand side of the chart and move forward with the price action, you will notice the clear structure of lower highs and lower lows(Downtrend). Which was maintained for the whole period we examined.
How to Spot Trend Reversal in Forex
The methods I outline here should be used within an overall strategy. Do not not count on one single method solely. Use multiple methods to confirm the trend reversal. I will explain this afterwards.
Method 1: Trend Structure Break
The first and most important method to find trend reversals is the trend structure break.
We have just explained in the previous part this method of identifying trends using the peaks and troughs. So what if the structure breaks?
A key warning the trend could be reversing or stalling is a breakout below the latest trough in an uptrend. Or latest peak in a downtrend.
While a structure break doesn’t guarantee a trend reversal, every trend reversal must be preceded by a structure break. It is an important development that should be considered in your decision-making process.
Breaking the latest trough in an uptrend or peak in a downtrend is important by definition, as this break will invalidate the uptrend or downtrend structure. Thus, the price no longer has the structure of higher highs and higher lows and therefore the trend could be reversing.
Here is a chart example of a clear downtrend structure that was violated by breaking the latest high.
Here is another example in for a structure break in a downtrend to reverse to an uptrend
Method 2: Trend Line Break
A widely used tool to define a trend is a trend line. A rising or ascending trend line is constructed by connecting the first two higher lows in an uptrend and extending the line into the future.
The opposite goes for a falling trend line. We need at least two lower highs to connect, and the trend line should be treated a resistance.
Here are some important tips to know about the use of trend lines to spot trend reversal in forex.
– The steeper the trend line the less reliable it is. And it will most likely be broken quickly. As sharp moves are usually indicative of excessive emotions and in most cases not sustainable.
– The longer the trend line and the more times that the trend line is touched by prices, the more significant it is, and the more significant the reversal when the trend line is finally broken.
– A break of a trend line is merely a warning signal, it doesn’t conclude a trend reversal, but warns of a possible
– Trend line breaks can result in corrections of the trend, not complete reversals.
– The breakout of a trend line is one tool that should be used alongside other technical tools and within a broad trading strategy.
Here is a falling trend line bullish breakout and reversal.
Here is a rising trend line bearish breakout and reversal.
This is an example of accelerating trend lines. Then a break of the main ascending trend line and reversal.
This is an example of ascending trend line break that resulted in a correction not a complete reversal.
For more details of trend lines and how to draw them you can check the technical analysis basics tutorial trend lines chapter.
Method 3: Reversal Chart Patterns
Trend reversal can also be preceded by a price action patterns. Here are the most reliable reversal chart patterns to watch for a trend reversal signal:
Double Top and Double Bottom
The double top pattern consists of two peaks separated by a trough. Both peaks must happen roughly near the same price (less than 5% percent difference).tHE pattern must form after an uptrend, and it suggests a downside reversal or a deep correction.
The double bottom is the exact opposite of the double top.
Triple Top and Bottom
Triple top is like a double top, but it consists of three peaks instead of two. And two troughs instead of one.
And the triple bottom is the exact opposite of a triple top.
A Rectangle is simply a sideways movement that consists of multiple peaks and throughs, that is contained above a horizontal support and below a horizontal resistance.
A downside potential target of the breakout is identified by measuring the distance from the highest peak to the trough between the two peaks. Then projecting this distance from the point of breakout (This is called the Measured Rule).
The rectangle can be a reversal or a continuation pattern depending on the direction of the prior trend and the breakout.
Head and Shoulders Patterns
Head and shoulder top pattern consists of three swing highs. The middle(second) high is higher than the first one, and the third high is lower than the second one and near the price of the first peak. The target is also identified by the measured rule just like the double top.
A head and shoulders bottom is a bullish reversal pattern. It is the exact opposite of head and shoulders top.
Cup and Handle Top and Bottom
A cup and handle pattern is rounding patterns that is formed when the price reverses direction gradually and in a slow manner. The reversal forms a curve like shape. The price then enters a small and short pullback, before resuming the upward reversal. The target is identified by using the measured rule(the distance between the lowest low in the pattern and the lip level.)
ABCD and Three Drives Patterns
The ABCD is a three wave pattern. Two main waves and one corrective wave. The ABCD pattern can be bearish ABCD or Bullish ABCD.
If you are not familiar with the ABCD and Three drives patterns you can check its explanation here
Method 4: 200 Days Simple Moving Average Crossover
The most important moving average crossover is the 200-days simple moving average. If the price crosses and settles above the 200-days SMA its a relatively reliable bullish trend reversal signal. And a the opposite is true for bearish crossover.
Generally, I do not recommend using other shorter term moving averages crossovers as a main tool to find trend reversals. However, you can use it within broader trading strategy as a supporting tool.
Method 5: Candlestick Patterns
Some reversal candlestick patterns can be used as a good warning signal of a coming trend reversal.
The High wave candle
The high wave candle is a gigantic candle. Its range can be longer than the range of whole month of trading. Usually happens following an unexpected and unscheduled significant news event.
To be a high wave candle, the candle range must be MORE than 6 times the average range for the past 14 periods. (The longer the better). If you can’t decide manually, you can use the Average True Range (ATR) indicator to and follow the steps in this tutorial.
The Long-legged Doji
The long-legged doji forms when the opening and closing prices are equal or near equal. And upper and lower shadows are noticeably long.
If forms after an uptrend, the pattern suggests the buying pressure is no longer in full control. It is fifty-fifty now between buyers and sellers. Therefore, the uptrend may stop for correction or reversal. The opposite is true if the pattern forms following a down trend.
Method 6: Volatility Spikes
Unusual spikes in volatility can be an indication of a coming trend reversal.
You can use the ATR indicator find instances of volatility spikes.
How to Identify Trend Reversal in Forex: Chart Examples
As I mentioned earlier, always look for multiple signals of trend reversal to confirm your view. Here are some examples:
We had a rectangle pattern form after an uptrend, meanwhile volatility was at elevated levels. That was followed by a downside breakout of the rectangle, confirming a trend reversal. The breakout of the pattern has also resulted in a trend structure break. Few days later, the 200-days simple moving average was broken, confirming the reversal further.
In the chart above, the price volatility has picked up following a major downtrend. Meanwhile, the price was forming a head and shoulders bottom reversal pattern. After the completion of the head and shoulders pattern, the trend structure was broken as well. The price then extended above the main falling trend line for the trend. All suggested a new up trend in place.
This is an example of a high-wave reversal candle. By definition a high wave will surely be accompanied with high volatility, and therefore the chances of a trend reversal is high.
I hope you will be able to pinpoint trend reversals like a sniper after this tutorial. Remember to always manage your risk properly with each trade you take.
And finally I would love to know which trend reversal method you prefer. Please write your preffered method in the comments section below.