How To Identify A Trend Reversal In Forex Trading
In forex trading, a trend refers to the direction of the price of a currency pair(s) for a period of time. A trend can be long-term or short-term and can move in an upward direction or downward direction.
Traders use several tools at their disposal, study various market conditions, and conduct fundamental analysis to identify trends because it puts them in a position where they can make profitable trading decisions and protect their profits from risks.
While a trend can keep going in a particular direction for days, weeks, months, and even years, the market can show a significant move that causes price movement to change. This is called a trend reversal.
What Is A Trend Reversal?
A trend reversal happens when the price of a currency pair changes direction. For instance, if the price has been experiencing an upward trend and starts moving downward, it can be regarded as a trend reversal. Trend reversal means different things to different traders depending on the time frame they are using. For a forex day trader, changes in a trend for as little as 5 minutes can be seen as a trend reversal because they make their money based on daily price movements, but this might not matter much to a long-term trader.
Generally, small changes or counter-moves are referred to as pullbacks and impulsive market movements either in an upward or downward direction are called retracements. What separates these other price movements from a trend reversal, is that they often last for a very short time and do not indicate much change in the overall trend.
Identifying a trend reversal early can make all the difference between having a big win, suffering a loss, or breaking even while trading. Also, knowing the difference between an actual trend reversal and something temporary like pullbacks can affect your profit-making ability because false signals happen all the time in the forex market and being able to spot them can affect your trading decisions.
Identifying Trend Reversals
There is hardly any method or technique that can guarantee 100% accuracy when identifying trend reversals and the best thing these methods can do is help you to identify possible areas where the trend might reverse. Methods traders use for identifying potential trend reversals include:
Trading The Shark Harmonic Pattern
The shark harmonic pattern is a 5-point harmonic pattern that was discovered in 2011 by Scott Carney. This pattern is a reversal pattern and what differentiates it from other harmonic patterns is that its five points are labelled OXABC rather than XABCD like the others.
Asides from its labelling, the structure of the shark pattern is quite similar to various harmonic patterns like the Bat, Crab, and Cypher patterns. There are several Fibonacci ratios that need to be met to validate a shark harmonic pattern and once the pattern is formed on the chart, it can predict potential price movements.
Some major trading platforms like MetaTrader4 come with indicators that can identify the shark pattern in a chart. If the trading platform you use doesn’t have a shark pattern indicator, you can draw it yourself, but this takes time and considerable effort because of the requirements that need to be met. The requirements for a valid shark harmonic pattern include:
- AB leg is a 113% to 161.8% retracement of XA
- BC is an extension of OX by 113%
- CD is a 50% retracement of BC
- The distance from point O to point C is between 88% to 113%
- The price swing of the BC leg is a 161.8% to 224% extension of XA
Where the platform comes with the XABCD pattern indicator, you can also use that to identify the shark harmonic pattern on a chart.
When using the shark pattern to identify trend reversals and trade, it means that you are working under the assumption that a potential price reversal is underway. The first thing to do is to look for an entry point at point C or point D, depending on how your pattern is drawn, where the retracement of D to X (or C to O) is between 88.6%-113%. You can also set a flexible stop-loss order at or below the 113% Fibonacci extension of XA or set a more protective stop-loss order at point C (or D) in case the price breaks through that point.
The final step is to set two TP (Take Profit) levels using the pattern. The first TP zone is typically set at the 50%-61.8% Fibonacci ratio of the BC swing, and the second TP target can be set at the point A or C levels.
The shark pattern and the requirements you’ve put in place will work if there is an immediate price reversal, but you should be a bit cautious when trading with this pattern because it is relatively new. Also, the shark harmonic pattern works best with identifying short-term trend reversals.
Using Trend Lines
Trend lines are common tools used by traders, and using them on a chart is a simple way to identify trend reversals visually. Trend lines can be horizontal or diagonal and to identify reversal signals, these trend lines will serve as support and resistance levels.
The first step is to draw two trend lines. You can draw the upper trend line by connecting two or more high price points, and the lower trend line is made by connecting two or more low price points. If you want to save some time, you can use the trend lines indicator available on the trading platform, and this will automatically connect the most significant price points on the chart.
For a trend reversal to happen, either the lower or upper trend line will be breached as the price starts to move in the opposite direction. For example, if there is a breakout with lower highs and lower lows, then you can expect an uptrend reversal. Where there are higher highs and lower lows, it means that a downtrend reversal is taking place. But a breakout from a trend line may not necessarily mean that the trend is over and to confirm the reversal, it is necessary to use other forex indicators.
Using Moving Averages
Moving averages is a common technical indicator among forex traders, and it is simply the overall average of the movement of a currency pair over a given period. There are different types of moving averages, with the two major types being the Simple Moving Average (SMA) and Exponential Moving Average (EMA).
The best way to use moving averages to observe price movement and identify potential trend reversals is by using different moving averages together on a chart. These will keep track of the trend at varying degrees and allow you to react to any reversal quickly. For instance, you can use a 20-day MA along with a 50-day MA or something longer like a 200-day MA to observe the trend.
However, you should avoid using too many MAs on a chart to avoid any drawbacks. Also, it is preferable to use a moving average along with other indicators to increase the probability of accurately spotting reversals.
Now that you know some of the different techniques used in identifying trend reversals in forex trading, it is important to realise that using one of these methods alone might not give you the accurate results you are looking for. Instead, combine a few methods together to increase the probability of spotting trend reversals early.