Reversal patterns, as the name suggests, change the course of an ongoing trend, whether it is bearish or bullish.
For example, if the price action indicates that the trend is moving upwards, then this should eventually see an end to the course of the ongoing trend. And a reversal to the downside should be initiated.
Reversals can be easily spotted on the charts. However, beginner forex traders usually identify them after they have already taken place.
In this article, we are going to explore the most commons types of reversal patterns, to help FX traders identify them on time.
Most Common Reversal Patterns
While there are many reversal patterns to consider, we put together a list below, identifying some of the most common ones to add on your cheat sheet:
- Double Tops and Double Bottoms
- Triple Tops and Triple Bottoms
- Head & Shoulders and Inverse Head & Shoulders
- Ascending Wedges and Descending Wedges
Each one of these reversal patterns occurs several times during a forex trading session.
The occurrence, however, depends on a number of different characteristics. Price action is one of them, and volatility is another.
How to Identify Reversal Patterns
One of the best ways to identify reversal patterns is through price action.
Price action can help an FX trader spot both reversals that are about to occur, as well as ones about to follow.
Price action behavior around previous highs/lows, around trendline support/resistance and confluence levels, is of paramount importance when trying to establish a trend reversal signal. Along with that, candlestick patterns such as the doji, engulfing or pinbars, to name few, can add some validity to the incipient reversals.
All of the above can provide signs of exhaustion leading to potential reversals. Exhaustions are usually accompanied by consolidations, which can be another sign of an impending reversal.
Now, a forex trader can also use a number of indicators such as the RSI & Bollinger Bands to validate reversal signals. One has to check for overbought/oversold conditions on the RSI 70% / 30% levels, and the deviations or even the breaching of the bands when using the Bollinger Bands indicator.
Finally, the Fibonacci extension can be useful to make an assessment of price action. If for example the 2.618% extension has been reached, then conditions are favoring a potential reversal.
How to Trade Reversal Patterns
Once any of the aforementioned conditions signal a potential turn-around, we look for a price breakout in the opposite direction.
There are different ways to trade a reversal, from revisiting a support/resistance level to waiting for a valid retest of the first breakout level and then taking a trade. A good breakout to keep in mind is the neckline breakout.
A neckline is an area of diagonal support or resistance, or a trendline if you will. This keeps prices trending for an extended period of time when not breached. In our case, we are looking for this trendline to weaken and break for a reversal to commence, hence, a valid trade.
A Live Example
In the USDCHF 15m chart below, price is trending to the higher side for an elongated period of time.
An FX trader can easily spot the major resistance zone and the continuous price rejections at the top, which is an indication of a potential impending reversal.
The chart shows a double top that came following a false break, another sign of trend change. We can see a doji candle forming that double top. We can also see a hanging man pattern following the doji, as well as an engulfing pattern following that; all supporting evidence.
All the above triggered a neckline breakout, which saw a retrace for a valid retest of the neckline resistance.
This is a conservative way to trade the neckline breakout of a reversal pattern. One can opt to trade them aggressively, however, keep in mind that false breakouts are seen more often than not.