Reversal Signals and Patterns are formed based on the price action between the bulls and the bears and is an indication of the end of a trend, the beginning of a trend and retracement within a trend. These signals and patterns are very useful to traders as it provides a guideline to close existing positions and to open new trades.
There are various types of Reversal Signals and Patterns of which the most common ones are:
- Trendline penetration Signal
- Head and Shoulder Pattern
- Double and Triple Tops and Bottoms
The ones I have mentioned are easily identified,simple and effective for any style of trading. It is important to note that Reversal Signals and Patterns only exist in a trending market and when they have been identified, I recommend that they should be coupled with other factors as confirmation to support the potential reversal at the price range or the price levels where these patterns are formed. Some of these factors are:
- Monthly, Weekly and Daily Support and Resistance levels
- Candlestick formations
- Previous market behavior
I will be doing a series this month on these Signals and Patterns and will elaborate on Trend line Penetration in my first of the series.
Trendlines are of extreme significance to the strength of a trend and is represented by a straight line connecting support levels in an uptrend and resistance levels in a down trend. Some traders draw their lines connecting the levels of the candle close but my preference is connecting the actual price levels of the highs and lows.
Studies have shown that trendlines with a 45-degree angle gives more credence to the stability of the trend as you will see in the chart illustrations below .
When a trendline is penetrated in an uptrend that very same line now acts as resistance and since all time frames will illustrate varying trendlines of support and resistance; a potential reversal set up is best observed on a larger time frame such as the Daily chart with a daily candle closing below the trendline and a high has been formed signifying and supporting the potential reversal.
Similarly, the reverse is true when trendlines are broken in a downtrend. A low should be observed on the daily chart and a candle close above the trendline which will now become a support line.
REVERSAL AFTER AN UPTREND
NZD/USD DAILY CHART
The above chart gives a birds eye view of the breaking of the long term trendline on the daily Chart to support my explanation on potential reversal set up in an uptrend.
NZD/USD DAILY CHART
The above chart gives us a closer look at the specific candle which closed under the trendline on May 2, 2012. As you will observe the trendline now became resistance and the bears took control of the market.
The yellow shaded area represents the high being formed; a high consists of a candle with a minimum of 2 candles to the left and the right which have closed lower than the center wick low. Now there are 3 reasons to confirm the reversal: the high formation, the Trendline break and the close of the daily candle below the trendline .
REVERSAL AFTER A DOWNTREND
USD/CAD DAILY CHART
The above chart gives a birds eye view of the breaking and close of the daily candle above the trendline after the strong down move. As you will see I have 2 trendlines: the blue line is connecting the the 2 highs in the initial down move and when a lower low was made instead of adjusting my trend line I drew a new line represented by the red line connecting the highs followed by the last low.
You may ask why?
On the larger time frames I always maintain my old trendlines; and as you can see from the daily chart illustration, the blue trendline commonly called the inner trendline acted as strong support and the red trendline commonly called the outer trendline acted as resistance before the candle break and closed above the red trendline. The outer red trend line is more significant in a potential reversal of trend.
Some charting packages includes a feature where trading tools can be linked to all time frames. In this instance my trendline was automatically linked to every time frame. This allows me to easily refer to price action on the smaller time frames as an example: 24 candles on a 1 hour chart represents 1 daily candle.
USD/CAD DAILY CHART
The above chart gives a closer look of my prior explanation of the purpose and significance of the inner and outer trendline. If you notice there are 2 candles which closed above the red line as indicative by the arrows. The first candle close above the line even though small still remains a reversal set up with the second candle closing higher than the first candle close is confirmation of the trend reversal.
Have you noticed how the lines become support upon the break and the close of the candles?
The yellow shaded represents the low formation at the inner trend blue trendline where there are more than 2 candles that have closed to the left and right of the center wick high.
Now we have more than 2 reasons as explained for the trend reversal.
My personal approach is having several reasons to confirm potential trade opportunities.
HOW DO WE TRADE TREND LINE PENETRATION?
When the trendline is broken and all that has been explained aligns, there are several scenarios in how to enter and exit the market.
. If you are a position trader you can enter on the opening of the daily candle preceding the daily candle which closed above or below the trendline in the direction of the new trend or wait for a test of the trendline and placing your stops below the low of the candlestick formation or above the high of the candlestick formation if equity management allows or placing stops below or above trendline and according to your equity management rules.
. Short term traders usually look to a smaller time frame such as 15mins, 1hour and 4 hour charts for candlestick patterns or counter trendline break to enter their trades whilst minimizing their risks
Take profit targets are identifying levels of support in a downtrend and levels of resistance in an uptrend to exit your trades. Long term or position traders will focus on monthly and or weekly levels (and I would recommend keep locking profits as the trade progresses) while day traders focus on daily levels of support and resistance.
Remember the market can do whatever it wants hence my mention of locking profits during trade progression. Nothing in the forex is written in stone and good equity management is the key to consistent profitable trades.
I hope this article will be beneficial to all.... GOOD LUCK and I welcome your feed back.