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How To Identify Trend Reversals In Forex

It happens at least 3 times a week.

Every couple of days, we get the same email from another confused trader: how to identify trend reversals in forex?

Here’s the thing: trend reversals are not hard to spot.

Most of the time they are as obvious as night and day.

So what’s the big problem then? Why all the emails? Where does all the confusion come from?

Well, it’s the same thing over and over again. The problem is this: most traders make it far more complicated than it needs to be.

So let’s strip away some of that confusion now.

Let’s simplify trend reversals and take things back to basics. Less focus on things that don’t really matter – and more focus on making money.

This article will give you an easy 5 step process to identifying when a trend is reversing, when to act and how to take maximum advantage.

Let’s get started.

Step 1: Find a trend to reverse

You’d be shocked at the number of people who jump straight into find finding trend reversals before actually finding a trend in the first place.

Sounds stupid, but us forex traders are fond of jumping the gun on some of these things, aren’t we? Identifying trend reversals is no different.

So we need to start at the start.
And that means not going off looking for trend reversals before we’ve even confirmed that there is a trend there to reverse.

The thing to bear in mind at this stage is this: don’t over-think it.

Don’t get confused and bogged down in the detail. Clear all your indicators off your chart and get it nice and clean. Zoom out. If a trend jumps off the screen, it’s likely that you have something to work with. See the image below and ask yourself if there is a trend in place and what direction it is moving.

how to identify trend reversals in forex-trend 2

Pretty obvious, right?

If you have to lean in closely, squint a little and scratch your head, it’s likely that there’s no trend there.

What about this one?

how to identify trend reversals in forex - no trendf 3

If there’s no obvious trend on your chart, change instruments. There are thousands of markets to trade. Keep looking until you find a trend that jumps off the screen at you.

Step 2: Decide what trend reversal indicator you are you going to use

So now should have identified an instrument that looks like it’s trending.

Next it’s time to take a closer look – we need to add some context to that blank chart.

And that means adding some indicators, or looking for some patterns.

Indicators (or chart patterns) usually kick off all sorts of problems with traders. It’s like traders hear the word “indicator” and their brains starts to malfunction with all the choice available.

The hundreds of different indicators, thousands of different settings, an infinite number of combinations. It’s too much to process.

But remember – we don’t need to get bogged down in any of this.

Here’s the thing: doesn’t really matter what trend reversal indicator you use. There’s not much difference between them. I realise that saying this almost heresy in the world of trading – but it’s true.

It’s a bit like a runner buying a new pair of trainers before a race. There’s a huge choice of different types and styles to choose from. But ultimately, there’s not a huge difference between them all - and picking one over another isn’t going impact the end result very much. It certainly isn’t a substitute for good training, sleeping well, eating properly beforehand, etc.

A brand new pair of expensive, top of the range trainers aren’t going to make much difference to the runner who has done his training and is well-prepared. A reasonably good pair will be all the runner needs to do well.

Likewise - one indicator versus another isn’t going to make much difference to a trader who knows how to trade properly. A reasonably good indicator will be all the trader needs to do well.

So relax – take it easy, no more agonising over the endless choice. Just pick an indicator that you like using. No pressure – there’s no right or wrong. All of them have pros and cons.

You can spot a forex trend reversal with any the following indicators/patterns. You’ll not go too far wrong using any of these:

Watch for a break in a pattern of Higher Highs and Higher Lows

Forex trends move in waves. These are often known as higher highs and higher lows (or in a bearish market, lower lows and lower highs).

how to identify trend reversals in forex - higher highs 4

For simplicity, we’ll just refer to the bullish pattern – higher highs and higher lows. Just switch it around to get the bearish alternative.

If you can spot a series of higher higher highs and higher lows in the forex market, congratulations – you’ve spotted a trend. When that pattern ends, the trend usually ends with it. (We’ll look more at how the patterns ends in a moment)

  • Pro: one of the oldest, most-watched ways of identifying a trend
  • Con: can sometimes be difficult to spot in real markets

Wait for a break above/below a Moving Average

You can also use moving averages to tell you when a trend is beginning to reverse.

When you are using certain moving averages – you know that you have a lot of big traders behind your back.

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Take the 200 day simple moving average for example: the 200 day will be on the screen of some of the biggest banks and fund managers. If a market falls below the 200 day moving average, it’s a big deal. It’s a sign that the trend is coming to an end and possibly reversing.

(If you’re interested in a strategy that uses moving averages, check out the 3 Little Pigs Trading Strategy and its moving average MT4 trend indicator)

Another popular moving average strategy is watching for crossovers. Many algorithmic black box traders use moving average crossovers to monitor the health of a trend.

One combination they use is a 20 and a 50 combination – but other combinations can be used too.

The sign is when one moving average crosses over the other.

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If you are interested in using moving averages in your trading, you should check out this moving average trading strategy.

  • Pro: you can be confident that you’ll be watching the same signal as the big traders
  • Con: moving averages can struggle in choppy markets

Candlesticks

Traders have been using candlesticks to interpret market trends for years.

A lot of traders get put off by the stupid sounding names that people give the different patterns. Don’t worry – you don’t need to learn any of that.

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The only topics you need to know are:

That’s all you need know about candlesticks. Those patterns are all great indicators that a trend reversal could be on the way.

(If you’re interested in a strategy that uses candlesticks to identify trend reversals, check out the PAST Trading Strategy and its MT4 Trend Reversal Indicator)

  • Pro: One of the earliest indicators of a trend reversal
  • Con: Lots of failed signals in a strongly trending market

Chart Patterns

Chart patterns are another popular way of identifying when a trend might be beginning to come to end. There are lots of different types of chart patterns you can use, but one of the most widely used one is the head and shoulders pattern.

When you see a head and shoulders pattern, it’s a sign that buyers are running out of momentum and the trend could be on its last legs.

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  • Pro: the most widely used technical analysis you can get
  • Con: can sometimes be tricky to draw in real markets

Other Trend Reversal Indicators – Honourable Mentions

As we’ve said already, there are a lot of different ways you can identify trend reversals. If none of the above appeal to you, you can try some of the honourable mentions below:

Divergence

Pivot Points

Mean Reversion

Ok – so is your head spinning yet? Crippled by choice?

If you’re wondering how you decide which one to pick, there’s some good news for you – it’s easy.

Forget about trying to find out which one works best – because you’ll never get a firm answer to that question. You could spend years testing the different types and still not reach a worthwhile conclusion.

Just pick one that you like the look of and makes sense to you.

And go with it.

Using Your Trend Reversal Indicator as a Tool

Once you have your chosen indicator/pattern, now it is time to get used to it - practice it - see it as a tool.

Here’s an example. A chisel is a fairly simple tool. The first time you try to use it though, you’ll probably hack the piece of wood into an ugly mess.

But if you practice using it, over time you will see what you can do with it - you will understand its limitations, and you will be able to create beautiful sculptures.

It’s the exact same with your trend reversal indicator. The first time you use a head and shoulders pattern, or a moving average, or whatever you choose - you’ll probably make a mess of it. You’ll probably struggle to figure out if what you’re looking at it a valid pattern at all. You’ll likely wonder if you could make some tweaks to make it better. And if you have a few losing trades, you’ll probably think the indicator you’re using is a load of rubbish and you’ll want to try something else.

Resist!

The solution is not to move onto another tool - the solution is to practice with, and eventually master, the one you’ve got.

Step 3: The Trend Reversal Event

So now we’ve got a trend, and we’ve got an indicator or chart pattern telling us that a trend reversal might be on the cards.

Now we are onto stage 3 of the 5 stage process. We’re getting down to business now.

So what’s a “trend reversal event”?

A trend reversal event is as follows:

it’s a specific set of circumstances that, once they happen, it tells you that a trend reversal has occurred.

This is not something you can make up as you go along. You have to define it in advance. If you wait until you are in the middle of a moving market, and money is on the line, your ability to make clear decisions will be clouded.

Here are some example trend reversal events for each of the indicators mentioned above:

  • Higher Highs and Higher Lows

Trend Reversal Is When: A candle close below the last higher low on the daily timeframe means that the trend has reversed.

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  • Moving Averages

A candle close beneath the 200 day moving average on the daily timeframe means that the trend has reversed.

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When the 20 day moving average crosses the 50 day moving average on the daily timeframe means that the trend has reversed.

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Chart Patterns

A candle close beneath the head and shoulders neckline on the daily chart means that the trend has reversed.

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Candlesticks

A close below the most recent up candle on the daily timeframe means that the trend has reversed.

Notice how each of the above events refer to a daily close candle. There’s nothing magical about the candle close – it’s just that it’s a clear, obvious event. If it happens, you can’t argue about it.

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You can change these events to whatever you want. It could be a different timeframe, different level to breach, whatever. The only thing that is necessary is that when it happens, it’s obvious.

Now, this doesn’t necessarily mean that the market is going to collapse and steam off to the downside. It’s just an indicator that the bullish power behind the trend is weakening. This could prompt a move to the downside, or the market could also start to range for a while.

No second-guessing.

It either happens or it doesn’t.

Now onto the next part – this one is important.

Step 4: Take Action – Take Your Trend Reversal Trade

So let’s recap:

1: We’ve found a trend.

2 :We’ve decided what indicator or chart pattern we’re going to use to tell us that the trend might be coming to an end.

3: Our specific Trend Reversal Event (that we’ve decided upon in advance) has occurred.

Now it’s time.

Your signal that you have been waiting for has happened – now it is time to spring into action.

Traders often spend hours thinking about what they are going to do when x,y or z event happens. Yet when what they have been waiting for actually happens, they freeze. They start second-guessing themselves, introducing new indicators into the mix, looking at different timeframes – basically talking themselves out of taking action.

If you are already in the market, this is a signal that you may have to close a position.

If you are waiting for a trade to set up, now it might be time to open a position (make sure to set your stop-loss first).

Have some confidence in your analysis – if you have got to this stage – there’s a really good chance you’re onto something. Trust your analysis – trust the chart – and take action.

A Word About Failed Patterns

Here is one thing you are going to have to come to terms with as a trader. Patterns will fail. They will fail all the time. A 50% failure rate would not be unheard of at all. And if your pattern only works 50% of the time, you should be prepared to go on a losing streak of at least 15 trades in a row.

Many traders baulk at this statistic - but that’s the wrong reaction. Because if your average winning trade is 100 pips, your average losing trade is 80 pips, and 50% of your trades are winners - then you are making great returns.

We talk about this a lot more in the Price Action Video Course.

I bet I know exactly what you’re thinking at this point.

You’re saying:

  • I know what you’re thinking – but what if a head and shoulders pattern has triggered but price is still above the moving average?
  • What about when the trend has reversed on the daily timeframe but is still different on the weekly timeframe?

That brings up onto the most important one of all – the final section:

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Step 5 – Stay Consistent

This is the most important one of all.

Now you have learnt practically everything you need to know about identifying when a trend is reversing in forex.

  • You can identify a trend (think like a 4 year old and let it jump off the screen)
  • You have an indicator or chart pattern that alerts you to the possibility that trend might be coming to an end (one you know isn’t perfect but you like using it so that’s all that matters)
  • You have a specific set of criteria that tells you when the trend has finished (specific trend event – no arguments)
  • And you know to take action, trust your analysis and either open or close your trade.

That is practically everything you need to know.

It’s not difficult.

But there is one way you can take all that excellent knowledge and piss it up against the wall.

And that’s Step 5 – remaining consistent.

Not staying true to your rules is the biggest mistake you can make.

  • If you have a few losing trades, don’t start tinkering.
  • Don’t introduce additional indicators that will only confuse your analysis and cloud your judgement
  • Don’t tinker with settings on indicators

Combine some basic analysis trend reversal analysis with some good risk v reward trades – and you have a lethal weapon for trading the markets.

That’s all you need.

In the Turtle Trading experiment, the turtles traders had a defined, specific set of rules that dictated when a trend was reversing. Anyone who broke the rule got sacked – simple as that.

This was for good reason. If you can’t stick to some basic rules, you’ve got no chance.

So – staying consistent means using the same indicator and the same rule over and over again. Until you at least have a few hundred trades, so if you are going to change anything, at least you are doing so based on some statistical evidence. If one day you’re looking at chart patterns, the next day you’re looking at a moving averages, and then the next you are looking at higher highs and higher lows  – you are going to be all over the place. It will be impossible to make a clear decision.

And you will lose money.

You know your rules – now stick to them. At least give them a chance to work.

Stay consistent.

So that’s it! Hopefully that has answered those of you who were asking how to identify trend reversals in forex.

What you Need To Remember

Here’s the takeaway from all of this:

If you can’t decide what a trend looks like, you can’t settle on how to tell if a trend is reversing, and you tinker all the time - you’re probably doomed.

If you can combine some sensible rules, with some decent risk v reward trading, some consistency and patience to allow the approach to work - you’re going to be well on your way to success.

What trend reversal indicator have you chosen? Let us know in the comments!

DISCLAIMER & COPYRIGHT

This update is based on my analysis on my charting package. It may differ to yours as it can be affected by time, market movements, charting packages and broker prices. I accept no liability for loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on any information in this report or analysis.