5 price features that set up a good reversal trade
Convergence of compelling reasons to take action
When different price signals come together, they present a compelling setup to take action. The best setups are those where many signals agree - and this is when they become very obvious so that when many traders see it, they all agree to take the same action.
In this EURJPY example we see several features come together to set price up for a bearish reversal - roadmap, resistance, chart pattern, candlestick pattern, confirmation level.
A roadmap (blue rising equidistant channel) provides guidance for traders. When this trend/roadmap becomes very extended, it guarantees interest in the trade, both traders who want to ride the trend and those who speculate that it will reverse.
- The currency pair becomes highly scrutinised.
- Vested traders would be inspecting the supporting trend line closely for signs of holding together or breaking down.
- Traders who missed the ride look for entry point.
- Contrarians look for reversal pattern.
- The roadmap itself provides a supporting trend line that will make or break.
A resistance appears when price runs into a previous level or when profit taking creates a level. This is a first sign of weakening and a rallying level that shorts would be looking at. An important consideration is the duration of resistance - the longer this level holds, the stronger it is.
The technical analysis mantra here - “the more significant the support resistance level the stronger it is”.
- The more obvious a level is so that ‘I see it, you see it and many sees it’, the more followers it has.
- Levels on higher time frame are stronger than those on lower timeframe.
- The longer duration that the level holds, the stronger it is.
- The more times the level has been tested or validated (by price encountering the support resistance and turning away), the more meaningful it is.
- Traders should assume that a level will hold until it is broken.
- When a significant level breaks, the outcome is a bigger move.
When price fails to go higher after repeated attempts, longs exit, shorts enter.
3. Chart pattern
In this EURJPY example, a triple top appears. Chart patterns are highly documented and have high probability outcomes. A triple top is a bearish reversal pattern i.e. has a higher probability of reversing. The appearance of this triple top chart pattern reinforces traders who want to short at resistance.
4. Candlestick pattern
Once traders zoom into the resistance and '3rd' top, the next feature to look out for is a bearish candlestick. A bullish candlestick that breaks the resistance on top will also fail the triple top pattern. A bearish candlestick like this big down/red candlestick here reinforces the resistance (that it is holding) and the triple top (3rd top observation is valid).
5. Confirmation break - trend line break, neckline break
The 5th feature is a final confirmation that observations 2- 4 are correct i.e. price is indeed reversing, embarking on a new opposite trend. This confirmation could be provided by the roadmap itself - the supporting trend line that holds the previous uptrend together is now it's nemesis. By breaking the supporting trend line, it is a clear trade signal for traders who observed 2-4 and are just waiting for confirmation. Another confirmation could come from the neckline of the triple top chart pattern. This neckline would ideally be a horizontal level. Some traders prefer confirmation from a horizontal level than a trend line because long trend lines are difficult to draw - a slight difference in gradient will show different results.
Putting it together into trade, entry levels
Ideal trades are with-the-trend trades because they last longer. However some times compelling reasons can come together like this EURJPY example that makes it irresistible to do a short. The most important clues here are the long duration/significant resistance on top and then the high probability triple top. Depending on a trader's psychology, trading method, there are at least 4 different entry levels in this example:
- First entry level - short right at the resistance - this entry theoretically offers the best reward - risk proposition. It is a 'risk' trade - trader places a short at resistance and a stop loss just across the resistance. If resistance is not valid, his short is stopped out with minimum loss. If the bet is correct, the potential gain is several multiples of the stop loss.On the other hand, placing a short at resistance depends on the trading experience/acumen of the trader. It lacks the benefit of waiting for more confirmation from the candlestick pattern (4) and the confirmation break (5).
- Second entry level - short at close of candlestick pattern. This entry 'gives away' some potential profit with a slightly later entry. Even if stop loss level is placed in the same way as the first entry, this trade entry level will have a higher potential loss. By making this 'sacrifice', a trader hopes to enjoy a better timing i.e. that the candlestick pattern is indeed the start of the new trend. He is also betting that the trade is more sound by demanding more evidence compared to the first entry.
- Third entry level - short upon trend line break.
- Fourth entry level - short upon break of neckline. Traders who enter based on 3rd or 4th entry level are likely to be conscientious rule-based traders. These entries are likely to have very larger stop loss levels.
It is important to note that trade signals don't always happen in the same way. Many of these signals no matter how strong or numerous can have possibility of failure - high probability setup does not mean 100% probability e.g. false break line break, bull/bear traps. Even a winning trade entry might not be split into 4 levels. Some times, a really big candlestick can show up to break the trend line and the neckline at the same time. Some times the trend line and the neckline might be the same and some times, they can switch the order which one comes first.
This EURJPY example comes from an old post (Dec 2009) updated with a better illustration and more explanation. It is a chart from a monthly time frame. Now some readers may think that it is no longer valid, or time frame is too highly for lower time frame traders. Never mind the date and the time frame, the concepts apply equally. The challenge is to be able to spot the 5 features coming together whenever and in whichever time frame you trade. To shortcut your trading, follow us on Twitter or subscribe to trading diary at The Alien Room.