Perhaps the most awaited topic in the series of Price Action would undoubtedly be the concept of reversals. Just like any other topic, price action traders comprehend reversals uniquely and logically.
Many traders out there in the industry think a reversal is nothing but a pattern. And if they spot that pattern, they just take action without having any logic behind it. However, reversals are not as simple as it sounds. There is pure logic that goes into it.
A Reversal is very interesting and important as this is the region where the large players pump in a huge amount of cash. So, if you accurately understand when the market is going to reverse, you are basically entering the market when the big boys are gearing up as well. Therefore, in the following topics, we shall discuss how price action traders interpret a reversal and stay ahead of the game.
Consider the chart below. We can certainly say that the market is in a downtrend. The market keeps making lower lows and lower highs. Do you think the market is going to reverse anytime soon? Well, the sellers seem to be pretty strong, so not yet.
Going forward, the market starts to pull back for the third time. There is one question that needs to be answered. Is the up move a pullback or a reversal? If you’re successful in answering this question correctly, the money goes in your pocket.
Now, from the below figure, we can see that the price starts to hold at the support and resistance region. From here, the market could continue its downtrend or could begin to head up north. Therefore, the hold region is the decision-making region. This is the spot where all the money is made in the market. Hence, let’s discuss this region in detail.
For a price action trader, there are two types of reversals.
- Reversal of the overall trend
This is the type of reversal where the market changes its entire direction. For example, let’s say the market is in an uptrend making higher highs and higher lows. At some point in time, the market halts for a while, violates the support and resistance and then starts to make lower highs and lower lows, which is basically a downtrend. This type of reversal is known as the reversal of the overall trend. If you can catch these reversals, you can consider yourself as a professional; as this is the region where the large players enter the market.
- Trend continuation reversal
This the most common type of reversal the price action traders anticipate to trade. For example, let’s say the market is in a downtrend. First, we determine the strength of the sellers and wait for a pullback (buyers) to come in. Once the pullback starts to kick in, we wait for the reversal of miniature buyers (essentially, buyers in the current time frame). Finally, at the reversal region, we prepare to short.
Analysing the real markets
Now that you have acquired some theoretical knowledge, here is an example which will walk you through the procedure to identify a reversal.
Below is the chart of AUD/USD on the 4H timeframe. The market is clearly in a downtrend. Since it is a downtrend, we wait for the price to make a pullback or the buyers to show up, so that we can go for the sell.
From the chart below we can see that the pullback has begun. Let us carefully analyse the pullback phase. Starting from the upward arrow, one green candle shows up. But, gets eaten up by the seller again. So, we can mark 0.75278 as the resistance level. Moving forward, the price this time breaks the resistance level and goes up till 0.75541. Now, we can say that the pullback is active. Once the market reaches up to 0.75541, it comes down until the S&R line, and then goes back up and breaks the most recent S&R as well. Now, observe the location of the market. The market is at the position where the sellers are sitting. In technical terms, we are in the supply region.
Now comes the most important piece. As discussed previously, we are in that region where the market could continue its downtrend or could shoot to the upside. Therefore, understanding this area is very critical. Well, let’s go ahead and analyse it.
Firstly, let’s observe the momentum of the market. Starting from the downward arrow, the market drops drastically in the first two candles; then it drops further down, but this time the size of the candles are smaller. What does this mean? This means that the sellers are slowing down. Moving forward, observe how the price reached up to 0.75541. If compared with the adjacent seller, the buyers were much faster and stronger. What about the next leg up. How did the market reach up to the supply area? It was strong and fast as well. Here, we can infer that the buyers are pretty strong in the market.
Now, let us examine the reactions from the supply area (0.75824). The first time, price came to the S&R line (0.75541) in just two candles from the supply area. If the sellers were strong, they would’ve broken the S&R, but they were unsuccessful in doing so. On the other hand, it also means that the buyers are not letting the price drop lower.
If you observe the following chart below, the sellers were unsuccessful the second time as well. But, the third time, the case was different. The price started to move above the 0.75824. This was the price sellers were interested in selling. But, for whatever reason, they don’t seem to be interested in selling anymore. On the flip side of things, the buyers are getting stronger every step of the way. This is when we can conclude that the market is going to blast towards the north.
From the below figure, we can clearly see that the market moved exactly how we interpreted it. The buyers just shot up with one gigantic candle.
From the above trade, it is evident that identifying reversals is vital in trading. A Reversal is not just a pattern, but is instead a story which is to be analysed carefully. The real price action traders always look for these opportunities since reversal trades always payout reward/risk. This is what it means to bring professionalism to one’s trading. Therefore, understanding reversals can take one’s trading to a whole different level. Keep this in mind if you are trading reversals the next time and let us know your results in the comments below. Happy trading!