5.9 Identifying Trend Reversals

Trend reversal.
There are several tools in your toolbox now that can help you identify the initial signs of a reversal of trend and take suitable trading action. And yes, you will hear people talking about a lot and though we discount those but before going further let's touch upon these but please read beyond these as the following may not necessarily indicate a trend reversal.
You could use chart patterns such as double tops, double bottoms and head and shoulders reversals to identify reversals. Ominous candlestick patterns such as dark cloud cover and evening star signal a change to the downside. Piercing pattern and the morning star candlestick patterns signal that the downtrend may have ended and changed to an uptrend.
Indicators and divergences are also useful to figure out if the trend is going to do the dirty on you!
Trend line breaks may prove to be dependable to indicate a possible but during strong trends a break may simple end up in a deeper retracement instead of a reversal.
If Fibonacci retracement levels break, especially 61.8% retracement level, look out for a possible change to trend. 
Pivot points may also be useful pointers to trend reversals.
Remember, R3-R2-R1-PP-S1-S2-S3? This was the pivot point level with three levels of resistance above it and three below it. As forex traders we know that most of the action is centered between the PP, R1 and S1 levels. If you see the higher levels of support (S3) or resistance (R3) broken by the price, sit up and take notice – a trend reversal could be forming. Like this.
These are just a few ways you could keep tabs on likely reversal points. 
However, all the above may only end up in a deeper retracement and we just can't depend on these to predict a possible reversal. 

Forget the Tools - Go Deeper in the Pure Price Action Theory

As we had mentioned that it is very difficult to predict a reversal because reversals are cause by a significant shift of sentiments because of major fundamental changes. And because of this fact even identifying a reversal is also not an easy task. 
Let's check the following chart where even after a retracement of over 76.5% the uptrend continued. In the same chart you will also see a break of the trend line support which did not result in a reversal and the uptrend continued for 6 weeks:
Trend reversals can not be predicted by Fibonacci and trend lines. 
In such case how to identify a trend reversal? Well, the guru-mantra to predict a trend reversal can be as follows:
1) If during an uptrend the price to break below the support of the previous major retracement, it comes as the first sign of possible reversal. Similarly during a downtrend the price needs to break below the resistance of the previous major retracement.
2) After such breakout if the previous support turns into a resistance then reinforces the view that the uptrend may be on heading for a reversal. During a downtrend the breakout should result in turning out the previous resistance zone in a support zone.
Let's take a look on the same weekly chart of EUR/USD, once again, as an example:
Predicting trend reversal.
As we can see, none of the retracement was able to break below the support level of the previous retracement and during each occasion the uptrend resumed again. Let's see what happened next:
Example of identifying trend reversal by price-action.
As we can see that during the period of March to May the price-action came across a strong resistance zone around the psychological level of 1.4000. The subsequent fall broke below the support of the previous retracement and that was our first sign of a reversal. 
More importantly, the previous support turned into resistance and that made the reversal a real possibility. A few weeks further, we saw some support near the support zone of the retracement before the last one but then a breakout of that too took place; and that almost confirmed the reversal. See what happened next - a complete turnaround. 
Let's take a couple of more examples of charts which are self explanatory. The first one is a USD/CHF monthly chart and the second is a monthly chart of EUR/USD; both spanning several years:

Multi-year Downtrend of USD/CHF with the Possibility of Reversal

Chart for self exercise to analyze the possibilities of reversal of a trend.

Multi-year chart of EUR/USD with Uptrend and Reversal

Another example for the exercise for predicting trend reversal.
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  • Identifying Trend Reversals


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