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Five Techniques for Trading Reversal Setups

March 05, 2018 09:55

Source: Pexels

Trading reversals is a popular trading style. Traders tend to wish for picking the exact bottom and top and catching a strong reversal. One of the issues is that reversals are not that common. Another challenge is that trading reversals actually requires more precision than trading with trend setups.

This article explains the key factors when trading reversals and what traders should focus on.

Tip #1: Start with Trading Trends

I know. My first tip with trading reversals is... actually not to trade them. My feedback is rooted solely in my own mistakes.

Trading reversals might seem exciting, but it requires more experience. In my view, traders are better off with learning how to trade with the trend rather than picking exact turning spots.

Trading with the trend also requires developing a strategy and a trading plan, but ultimately, it's easy to observe by adding a trend channel or 1-2 moving averages on the chart.

Finding reversal spots requires a trained eye to spot a Support or Resistance zone where the price will stop and turn into the opposite direction. This is easier to do once you have been trading for a while, but not on your first day.

Tip #2: Use Candlestick Patterns

As mentioned above, picking tops and bottoms is difficult, but there is a way for traders to recognise turning spots – candlestick patterns.

Here's an example: the EUR/USD is approaching 1.25 key resistance level, but you are unsure to trade the reversal right at 1.25. The alternative could be to wait for a bearish candlestick pattern on the 4h or daily chart.

Once a bearish candlestick pattern appears, traders receive a confirmation from the market that the 1.25 level is, indeed, important. There is a higher chance that the price is responding to the 1.25 resistance, and that it will correct deeper.

Source: MetaTrader 4: Supreme Edition, EUR/USD daily chart, December 22, 2017, to March 1, 2018 - Please note: Past performance is not a reliable indicator of future results.

Tip #3: Find Points of Confluence

The concept of Support & Resistance (S&R) is key for trading. It is part of the market structure triangle that also includes trend (and momentum) as well as price patterns.

S&R becomes more important when multiple levels are clustered roughly in the same area. For instance, a S&R level becomes stronger when a Fibonacci level, weekly Pivot Point, trend line, and Admiral Keltner channel (part of MetaTrader Supreme Edition) line up at about the same point.

It is important to choose a couple of S&R tools rather than use too many. Otherwise, the only thing you see on the chart will be S&R levels, which defeats the purpose.

It is important to follow the following two steps: first, find the S&R tools that work best for you; second, look for confluence.

Tip #4: Use Divergence Patterns

Reversals become more likely when price momentum slows down. Traders can assess momentum strength or weakness by comparing high lows both on the price and the oscillator (watch the video below for more information about reading divergence):

  • The presence of divergence increases the probability of a reversal, but is not a guarantee;
  • The lack of divergence makes it more likely that the a trend continues.

There are a couple of important factors to consider when reading divergence:

  • The higher the time frame, the more impact divergence will have on the price;
  • Multiple divergence is a stronger signal than single divergence;
  • Use divergence in confluence with other reversal signs because the price is able to continue with the trend for a while despite divergence.

Tip #5: Use Chart Patterns

Last but not least, chart patterns are critical for understanding the psychology behind the price movements. Why? Because traders can assess the price flow and movement with deeper understanding.

For example, a bull flag chart pattern informs traders that the price is building a mild bearish correction within a larger uptrend. Traders can try to trade the continuation once the price breaks above the flag pattern. The opposite is true for a bear flag chart pattern.

The flag examples are actually trend continuation patterns, but there are also multiple reversal chart patterns available, such as:

  • Head and shoulders (bearish reversal);
  • Inverted head and shoulders (bullish reversal);
  • Rising wedge (bearish reversal);
  • Falling wedge (bullish reversal);
  • Double top (bearish reversal);
  • Double bottom (bullish reversal);
  • Triple top (bearish reversal);
  • Triple bottom (bullish reversal).

All in all, confluence and patterns are critical aspects when analysing the charts and spotting reversals. The five points mentioned above should help out with trading reversals, but remember to practise first!

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