Forex Reversal Patterns Explained
In this article
Have you ever come across a situation when the market changes its course, and you wonder how I can profit from it?
Today, we will tell you what forex reversal patterns are and how you can trade through forex reversal patterns.
In this guide, we are going to dig in on forex reversal patterns and how you can trade them.
What are forex reversal patterns?
Reversal patterns are chart formations that indicate that the current trend is likely to shift direction.
When a reversal chart pattern emerges during an uptrend, it indicates that the trend will reverse, and the price will soon fall.
In contrast, if a reversal chart pattern is seen during a downturn, it indicates that the price will rise later.
These patterns indicate whether the bulls or bears are winning the war. For instance, in an uptrend, the bulls are in charge, but when Reversal patterns develop, the bulls lose the battle, and the market falls.
Types of forex reversal patterns
There are plenty of forex reversal patterns, but the most common are:
Double Top and Bottom, Head and Shoulders and Inverse Head and Shoulders, Rising Wedge and Falling Wedge.
Let’s briefly explain them:
1. Head and Shoulders
The head and shoulders pattern, as well as the inverse head and shoulders pattern, form at the top or bottom of a trend and indicate a probable change in direction. It is made up of a succession of peaks and troughs, with two trendlines drawn at the pattern.
The head and shoulders pattern appears during an uptrend, whereas the inverse head and shoulders pattern appears during an upwards.
2. Double top and bottom
The price made two failed efforts to break through support or resistance levels, as indicated by the double tops and bottoms.
The double top resembles the letter M and strives to breach the resistance level. Thus, it represents a bearish reversal pattern. On the other hand, the double bottom resembles a W and fails to send the price below the support level.
It represents a bullish reversal pattern.
3. Falling and Rising Wedge
Two trendlines, either climbing or sinking, form the wedge patterns.
The two trendlines in the falling wedge are lowering, representing highs and lows. Thus, it represents a bullish reversal pattern.
How to identify forex reversal patterns?
Price action is one of the finest techniques to spot reversal patterns.
Price action can help you identify reversals that are about to occur as well as those that will follow.
When attempting to generate a trend reversal signal, price action behaviour around historical highs/lows, trendline support/resistance, and confluence levels are critical.
In addition, candlestick patterns such as the doji, engulfing, or pin bars, to name a few, might lend credence to impending reversals.
All of those mentioned above can indicate weariness, which might lead to potential reversals. In addition, exhaustions are typically followed by consolidations, which can be another indicator of an oncoming reversal.
To validate reversal signals, you can also employ indicators such as the RSI or Bollinger Bands. Simply look for overbought/oversold circumstances on the RSI 70 percent / 30 percent levels, as well as deviations or even band breaching when using the Bollinger Bands indicator.
Finally, the Fibonacci extension can be used to find reversals. If, for example, the 2.618 percent extension is reached, conditions are favourable for a probable reversal.
How to use the Reversal patterns?
A neckline is drawn on reversal patterns in order to use them. A neckline forms at a level of support or resistance and serves as an entry point for reversal patterns. If the price falls below the neckline, it indicates the start of a downtrend.
When the price moves above the neckline, it indicates that the market is in an uptrend.
The entry positions should be above or below the neckline rather than at it. In terms of stop-loss, a trader can divide the distance of reversal patterns from the neckline by two and then place a stop-loss.
A critical point to remember is that reversal patterns do not always indicate a change in direction.
Even when a reversal pattern occurs, the price may continue to move toward the trend. This is where a trader must exercise caution and wait for trend confirmation. Using technical indicators such as the MACD or the RSI, a trader can confirm the trend.
Trading with forex reversal patterns
To trade the reversal patterns, place an order beyond the neckline and in the direction of the new trend. Then aim at a target that is around the same height as the formation.
For example, if you detect a double bottom, place a long order at the top of the formation’s neckline and aim for a target that is the same height as the distance between the bottoms.
Don’t forget to set your stops in the interest of adequate risk management! A decent stop loss can be placed towards the centre of the chart pattern.
When looking for these patterns, seek shorter price reversals rather than longer ones, as lengthier reversals can provide false indications.
Here are the reversal patterns buy and sell strategies:
Reversal patterns buy strategy
- Find the pattern in a downtrend.
- Wait for the price action to go bullish before entering.
- Enter the trade above the neckline.
- Set a stop-loss near the recent low from the neckline.
- Exit the trade when the trend changes direction.
Reversal patterns sell strategy
- Look for the pattern in an uptrend.
- Wait for the price to go bearish before entering.
- Enter the trade below the neckline.
- Place a stop-loss near the recent high from the neckline.
- Exit the trade when the trend changes.
It’s understandable that traders want to know when a trend has shifted. A trend shift is frequently associated with a new opportunity and the possibility to get in on the ground floor of a major shift.
When a reversal pattern is in action, you should have techniques to confirm the trend change. You can rely on reversal patterns completely.
Jason Morgan is an experienced forex analyst and writer with a deep understanding of the financial markets. With over 13+ years of industry experience, he has honed his skills in analyzing and forecasting currency movements, providing valuable insights to traders and investors.
Forex Content Writer | Market Analyst