Reversals occur quite often, but if you do not know what to look for, you cannot trade them.
Reversals are one of the strongest price action setups and one of the easiest to trade. And because they occur so often, you can trade this setup exclusively and be a profitable trader.
Indeed, for many years, Forex trading strategy was solely focused on reversals. However, these days I trade more price action setups.
Reversal trades come in three parts:
Let’s break down each of these parts.
A preceding trend is a strong move by the bears/bulls heading into an area of support/resistance.
In the example above, the preceding trend is a very strong bearish move, indicating that there are a lot of bears in the market and very few bulls. If bulls were strong, then prices would not be trending down.
The preceding trend shows us that the bears (sellers) have strong control of price and are pushing price down into a support area.
The opposite applies for a bullish preceding trend, which would show bulls (buyers) trending towards resistance, as you see below.
A preceding trend can be formed by as little as one candle. If the candle is strong and covers a lot of price distance, I categorize it as a preceding trend for the purposes of reversal trading.
The example below shows a single candle preceding the trend.
Preceding trends are pretty simple. As long as you see a strong move heading into an area of support or resistance, you can consider it a preceding trend.
A reversal setup will have one to three indecision candles. The indecision candles need to form on or near the support and resistance areas.
If indecision does not form on or near to the area of support and resistance, it is not a valid reversal setup.
Why does it need to be in a support and resistance area?
An indecision candle in a bullish preceding trend indicates that buyers are possibly losing control and sellers may be gaining control. In a bearish preceding trend, it indicates that sellers are losing control and buyers may be gaining it.
However, an indecision candle does not indicate that price will reverse with any degree of certainty.
An indecision candle indicates only one thing…
Indecision!
You cannot take a trade based solely on indecision. The image below shows indecision forming between support and resistance. If you were to enter reversal trades based solely on indecision, it wouldn’t work out too well…
What about when a bullish preceding trend heads into an area of resistance (sell area) or a bearish trend into support (buy area) and indecision forms?
Well, then we get the makings of a high probability reversal setup.
But we cannot enter just yet, we need confirmation, which comes in at Part 3 of a reversal setup.
The reversal trend is the third and most important part of a reversal setup. This is where we make our profit!
After a preceding trend stalls at support and indecision forms, you often see a reversal trend. The image below shows a bearish reversal trend forming after indecision on resistance.
In this case, we saw a transition of power from a bullish preceding trend to a bearish reversal trend separated by a stall on resistance.
Where do you enter the trade, though? Let’s discuss that in the next chapter.
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