Identifying Market Reversals

The trader needs to know if a trend in the foreign exchange market is approaching a reversal, for 2 reasons. First: if we already have a position in a trend, it is desirable to get out of it before it reverses. Second, reversal is the time at which a new trend emerges, offering the opportunity to enter early in trading and earn more.

The probability of reversal depends largely on the strength of the current trend. There are several ways to estimate the strength of a trend – here are the 2 we recommend:

1. Visual analysis

See the maximum and minimum trend. If the corrections are short and the consolidation develops in narrow amplitudes, the trend is strong. In a strong bullish trend, the price closely matches the first support formed in previous highs.

In the case of a slow trend, the price falls below the previous high (the initial support) but remains above the previous low. A bullish sign on such a trend can be used to open long positions.

A weak trend can be recognized by a lower maximum. In this situation, traders will fear the formation of the “Head and Shoulders” pattern. A lower high in a bullish trend indicates a potential reversal of the market.

Let’s look at an example. It is necessary to distinguish support 1 (highest previous in a bullish trend) from support 2 (previous low in a bullish trend). This is a reversal when price breaks support 2.

2. Analysis of indicator

The ADX is one of the biggest indicators of a trend’s strength. The main line of the indicator rises as the trend strengthens. The magnitude of the ADX ranges from 0 to 100. The range 25-50 corresponds to a strong trend, to 70-75 to a very strong trend and to 75-100 to an extremely strong trend. The trend type (ascending / descending) depends on the location of the auxiliary lines: + DMI is greater than -DMI in a bullish trend; + DMI is lower than -DMI in a falling trend. The intersection of these 2 lines may provide input signals.

The ADX move above level 25 can be used as confirmation of trend disruption and reversal. The divergence between the ADX line and the price during a bullish trend – lower peaks in the indicator and higher peaks in the technical chart – is not a sell signal, but a sign of bullish position reduction.

It is very important for trend traders to distinguish reversals from mere corrections. We’ve put together the information that will help you do this in the table below.

  Correction / retract Reversal
What happens before? Strong price drive Anything
What was the cause? No causes Fundamental factors
Market Players Retail Traders Make Profits Large speculators deal with large volumes
Chart Patterns Few patterns (usually only patterns of candles) Reverse chart patterns
Time interval Short-term reversal, lasting no more than 1-2 weeks Long-term reversal, which lasts more than 2 weeks
Japanese candles Candles that indicate uncertainty: with long upper and lower shadows (rotating tops) Reversing candles – swallow, hammers, falling stars, etc.

Leave a Reply

Your email address will not be published. Required fields are marked *