Greetings and welcome. I’m Dr Sam. I have a start up fund business, a PhD and a professional research interest in financial markets analysis. I trust this site helps you with information I have picked up over 10 years of studying and trading financial markets.
Learn these three patterns. Learn these three patterns. Learn these three patterns.
I say this three times because being able to read charts is a very important part of my trade plans and trading education. There needs to be a clearly defined ‘reversal’ signal.
It doesn’t matter if it fails, so long as there are rules to identify it firstly, and identify also when the pattern has failed.
Spotting potential reversals needs to be systematic in financial markets trading, it cannot be guesswork.
Traders often recommend trading with the trend, and not trying to spot reversals.
This is great provided you know how to spot and verify a trend, however it is misleading, because you should really try to get in on the trend itself on a reversal, unless one is only trading breakouts (i.e. Swing trading), but even if swing trading, a reversal can give a good hint either that the breakout is imminent, or that a correction is either starting, or is over.
Traders, educators and so called gurus will often tell you – buy on a corrective dip. Or, ‘wait for a retracement’… so how do you know when the retracement is over then?
They did not tell you that. Here, we will go through it so never again will we have to worry about not being able to spot reversals.
Equally important is learning when to recognise that a reversal has failed. We’ll cover that too. We will do this systematically, in a rules-based fashion.
The 1 Bar Reversal
Firstly, the 1 bar reversal pattern. One cannot trade and live without understanding this crucial pattern in trading. It is so simple, yet most traders do not even know about it.
Very simply, a 1 bar reversal takes place when the market trades above the most recent high (the high of the last bar or candlestick). Then the market retraces back below that recent high, and beyond the close of the previous bar/candle and closes for the time period being measured.
OR. The market trades below the most recent low (the most recent candlestick or bar’s low), then closes at the end of that time period above the low of that previous candle, and indeed above its close.
This is a 1 bar reversal and it is a warning that the market could be changing direction. The beauty of this pattern is that it can be applied to any timeframe, and any instrument at all. I tend not to take them very seriously below a 30 minute timeframe, though they can be deadly accurate on 5 minute and 15 minute timeframes as well.
Here are some examples of 1 bar reversals on a chart of the US dollar vs Japanese yen currency pair.
An arrow below (green – buy) indicates an upside 1 bar reversal.
An arrow above (red – sell) indicated a downside 1 bar reversal.
Successes and failures
In each of these examples, the criteria mentioned above are met.
It is worth studying the difference between a 1 bar reversal candle, and a candle that does not qualify as a 1 bar reversal.
As you can see, some of the 1 bar reversals work and are followed through in the price action of the market and are thus forex trading strategy opportunities.
Others fail, the market simply reverses again either straight away or soon after.
The point is that this pattern give a clue that the market might be reversing.
There is an exception pattern I will mention. This is an ‘almost’ 1 bar reversal. These have a long wick (that is to say that the high or low is reasonably far from the close, leaving a long thin line either above or below the close portion of the candle body). They fail to meet the precise criteria, because they don’t CLOSE below the previous close (downside reversal) or above the previous high (upside reversal), but may follow through as a reversal in the same way.
An example would be the candle that is two forward in time from the second green arrow from the left on the above chart. As you can see, it has a decent wick, closes quite a bit higher than the low, closes fairly close to the close of the previous candle, and is followed, eventually by a dramatic upmove. It is worth noticing these as well, therefore.
What about applying this knowledge?
Firstly, they are not for using alone. This is like a spanner of a certain diameter in a toolbox. Other tools are needed, and it is not much use without something to screw or unscrew.
Nevertheless, we can look at the principles.
Here is how 1 bar reversal pattern can be used.
There are four very important price points to note.
Firstly, identifying the 1 bar reversal. We have just done that. The signal is confirmed once the candle has closed, either on the rule, or judgement based on the ‘exception’.
Secondly, the high/low and the close of the candle before the 1 bar reversal. The high is to be noted for a reversal to the downside (red arrow). The low is to be noted for the green arrow signal.
Why? In the case of an upside 1 bar reversal, if the price after opening above, moves below the low of the previous candle before the reversal, it could be an early warning sign that the pattern is going to fail. It is not a good sign at all.
Thirdly, the high/low of the reversal candle itself.
Why? A breach of this level generally suggests that the pattern has failed. It doesn’t mean the price is going to continue against the trade necessarily, but it is a good sign it will and it is certainly a sign that the indication of the reversal has been misread for other reasons, or simply the randomness of the market has gone against the pattern as it appeared – such failures must be accepted and risk controlled accordingly.
Fourth the 40%, 50% and 60% retracements of the reversal candle itself.
Why? Quite often the price will go back and test these levels before the reversal comes into play. Therefore, they provide excellent entry points for the reversal trade, allowing for a better point of entry, and accordingly less risk in terms of the raw number of points, ticks or pips between the entry price and a proposed stop loss order.
Trade. Buying (selling) the reversal.
Let’s take the fifth arrow in as an example (4th green arrow from the left). This 1 bar reversal as you can see, follows two very small candles, a possible sign that something big is going to happen in the market. Such indecision often precedes a clear play in a direction.
The first thing to notice is that it has made a new 4+ hour high, this is a good sign.
The second thing to notice is that it is itself a reversal candlestick of the Japanese candlestick pattern variety (hammer style). These are reversals of themselves, but aren’t very reliable on their own in my view. And it is not a very classical form of this hammer either. So I am not worried about it going back down too much off that information.
3 methods of entry
After the reversal candle closes, a decision is made that the signal is to buy. Buy immediately. This means confidence of the price simply continuing to go up, good if it happens. If not it could mean more loss in terms of points or pips than waiting for a retrace, so it is very important to factor this in when considering the size of the position to be taken and whether or not the trade.
After the reversal candle, the trader decides to wait for a retrace, for example, to 40%, 50%, 60% (or some other retracement) of the reversal candle. In other words, wait for the market to come back on itself, then place the deal in the opposite direction, getting in at a better price, and also allowing a tighter stop loss order. The downside of this is that the price may not retrace – as in this example we are now mentioning.
Pre-empting the entry. I only do this if the reversal candle in the case of a upside reversal, while it is forming, goes beyond the candle prior to the prior candle’s low and close. In other words, look back two candles, if the reversal candle has gone lower than the low at time minus 1, is now higher than the previous close (again at t minus 1) AND is higher than both the close 2 candles ago – t-2 – (and by default the low of the candle two candles ago) it may be an opportunity to ‘pre-empt’ the entry, but only under favourable conditions that won’t be covered in this post.
3 methods of exiting
The stop loss suggestions below are also significant (that’s why I suggested that these various levels ought to be noted, i.e. one needs to be aware of them). These assume the reversal is to the upside, the opposite is true for a downside reversal.
Tightest stop loss. A stop is placed 2 pips plus spread below the CLOSE of the candle PRIOR to the reversal candle. This assumes that the reversal candle has closed above this close.
2nd tightest stop loss. A stop is placed 2 pips plus spread below the LOW of the candle prior to the reversal candle. This assumes that the reversal candle has closed above this close. If it has not done this, it should immediately raise a red flag that the reversal might fail anyway.
3rd tightest stop loss. A stop is placed below the low of the reversal candle itself.
Any lower than this stop and the pattern can be said to have failed, however, it doesn’t mean it won’t succeed e.g. A couple of candles later, but usually with another reversal candle a little lower than the first. If the trader is really convinced he has he directional change right, and can find a suitable stop ensuring the target is at least the same as, and preferably double or more than the proposed stop loss level, it is feasible to have a protective stop lower than the low of the reversal candle, but this should be in only very rare cases.
Examples of entry and exits
E1 is the entry buy on the close of the reversal candle (second green arrow marked) – note the first reversal candle marked was a failed reversal.
E2 is a planned entry at the 50% retracement – note that in this case it would not have been filled.
S1 is the OPEN of the candle 2 prior to the reversal candle. It could be used as the most conservative stop loss area, and also the first sign that the reversal might fail.
S2 is the low of the prior candle to the reversal candle. This is the first clear sign that the reversal could fail.
S3 is the low of the reversal candle itself. A breach of this level is a serious sign that the pattern has failed.
Each of these three levels progressively increase the chances that the reversal is going to fail, and trades need to be managed accordingly.
In the illustration above, the first reversal fails, because the price goes below its low after the reversal.
The second reversal candle (which is also a bullish engulfing candlestick) leads to a strong trend in the direction of the reversal.
A strong reversal can be identified without any indicators in this way – with the bullish signal of the engulfing candlestick and the 3 bar reversal which occurs concurrently.
However, it is much better to have other indicators to help ascertain in particular, the momentum and trend of the market.
Notice that candle that fails, although a so-called ‘spinning top’, closes only marginally above the close of preceding candle.
This is why it is great if the reversal candle closes well above the open of a 2 candle prior bearish candle (for an uptrend reversal), because this can add an extra layer of protection, as the warning will be given of failure if the open of that candle is breached.
The USD has rallied agains the Canadian this week, helped in some part by the FOMC announcements earlier. Here is a M30 technical chart of the pair.
In the last post I mentioned trading the DAX and using trend envelopes, courtesy of my good friend and a legend of a trader, valeofx from the forex-tsd forum aka Hercs.
As a follow on from that trend which was held in place by the M30 trend envelopes. Here is a chart of today’s action.
As can be seen, the trend envelope on the M30 chart (displayed – Mauve line) and its accompanying 21EMA set to high/low/close acted as strong support for a continued rally, which was firmly corrected, possibly due to DAX December options expiry being today.
Today, the price reached and exceed the resistance 1 pivot level (R1), but closed just above it, before a 50+ point sell off. I favour further bullish activity today, since there is a failed hammer reversal (3rd bar in from the right) and indeed the failure shows a 1 bar reversal (2nd bar in from the right has a lower low, but a higher close than the hammer candle). I’m not holding out, but I think it will go up some more before the close of day. NB. This is educated guessing and not investment advice.
Looking at the USD index, it does appear to be consolidating, having said that, there has been strong USD buying of late. If we take the view that USD index is consolidating (correcting, going down) this means that the dollar will be making losses against Euro, Japanese yen, Pound, Swiss Franc, Aussie and Canadian dollar. My view is that if gains have already been made in any two of these currencies, but especially Euro and one other, gains which look like they are not likely to go much further, but the index is showing a clear pattern, it might be a sign to, in this case, sell the dollar against one of the other currencies, especially if that currency has been strong recently, for example, buy GBPUSD.
In other words, index seems to be going down, indicating short term dollar weakness (intraday). Euro and Japanese yen have already made gains against the dollar. These could continue to lead the index lower, but in case they seem to be stalling, or reversing, it might be worth looking for a reversal in the other pairs making up larger components of the index, particularly if those pairs have been posting losses against the dollar.
Here is the dollar index. Based on the post about quadrant trading the dollar index seems to be moving from the first sell quadrants (4 and 3) into the second sell quadrant (2). Could the index reach the bottom of quadrant (2)? It does not seem an unreasonable thought, especially given the confluence with the 61.8% fiboacci expansion.
The overall message here, is that the idea formed for the day on this basis, is that the dollar is in a weak (consolidation) position today.
It has made a new low, the SMA5 is turning down, the momentum of the SMA8 is slowing and there is a ‘double doji’ pattern (see the orange and pink triangles) which according to this very useful and thorough economics and trading blog post can be a warning of serious consolidation (sometimes).
To the upside, the two moving averages will act as resistance. To the downside, the selling of the USD is against the long term trend (turquoise line and purple lines).
In conclusion, the dollar index is a useful way to gauge the currency basket making up the index against the dollar. The immediate implication of the trend is weakness in those currencies against the US dollar (in an uptrend which we have clearly been in for months).
In the short term, there may be opportunities to sell the dollar down against other currencies.
Review of price action from a technical perspective with fundamental notes
I’ve noticed in intraday trade, the GBPUSD currency pair has been trading a trending move intraday, and almost invariably giving back more than 100% of that move in a given day. So the market might move up 40 pips in the morning, but by midday have gone down 60 pips. Or it might move down 35 pips in the morning, only to go up 100 pips during the (UK) afternoon.
Today I captured the market behaviour with some technical studies, using a four hourly candlestick chart and a one hourly candlestick chart, some trendlines, which we will be calling a ‘quadrant’ and some moving average indicators.
Without referring to the news yet, I just want to look today at the price action and where it took the pound.
Figure 1, the 1 hour (H1) chart shows the price going up steadly, but in waves and correcting down to the bottom (dark) trendline, from the top (dark trendline).
The exchange rate has clearly ‘bounced’ off the bottom dark line, indicating a resumption of the upmove, if we take only this chart into account.
Figure 1 – H1 chart this morning
First, I noticed how strongly this channel bounced during the morning. This is a one hour chart.
If we broke it down to a half hour chart, we would see a ‘3 bar reversal’ for sure – that is that the newly formed candle has penetrated the highest high of the last three consequetively downmoving candles, a powerful reversal pattern.
If we imagine the trend channel divided further into 4 channels (rather than 2), by adding two more parallel lines at the half way point between the midline and the top and bottom of the channel, and from the top we label the ‘spaces’ quadrant 1, 2, 3 and 4, it is not hard to see that the price has entered into quadrant 3, from quadrant 4.
I have approximated these quadrants in figure 2, below.
Jimmy Young who runs a live trade room and daily trade review and ideas service, has previously taught that entering into quadrant 3 from quadrant 4, is effectively entering the ‘buyzone’. Likewise, coming down into quadrant 2 from quadrant 1, is effectively coming into the ‘sell zone’.
This makes sense intuitively, because if you imagine that the price is trading within these channels and are going from one channel to another in waves, a strong move from the bottom or top channel towards the middle is likely to be followed through from quadrant 2 into 3 (and perhaps down to the bottom of 4) or from quadrant 4 up to quadrant 3, and onwards and upwards into 2 (and perhaps to the top of 1).
Look at what happened by later on in the day…again this is in the H1 chart – I have redrawn in the trend channels roughly, including the two aforementioned lines. Now quadrants 1,2,3 and 4 can be seen clearly.
You can see that the market price for spot pound/dollar kept rising, up through quadrant 2 and then stalled about half way into quadrant 3. The price then collapsed (during an important set of (hawkish presumably) Federal Reserve announcements.
Figure 2 H1 chart by this evening
Could we have moderated for over-aggression using this H1 chart, and thereby been cautious about trying to reach the top of quadrants 3 or 4 in the long play on the H1?
The answer is yes, by considering the higher timeframe. In this case let’s look to the H4 chart.
NB. Jimmy Young taught this analysis method on the H4 chart – a first reason to be cautious of quadrant trading too expectantly on the H1 chart.
As can be seen, the trend and channel direction (slope) does not match that of the H1 chart displayed.
Although the overall trend seems to be up – and therefore, we would expect therefore that GBPUSD could continue to correct upwards (i.e. correcting mid-long term from the Brexit collapse move earlier this year) on this basis, on the H4 chart, we are clearly in a pattern right now of consolidation – of lower highs being posted, and lower lows. Again, the trend channel bears this out.
Over longer time periods, the trend is upwards on both charts according to moving average indicators, which perhaps gave the H1 some impetus for a bit of a run up the channel. The moving averages on the charts (figure 2 and 3) speak for the direction of the trend – apart from the short term average (blue), the dotted line, turquoise line, purple line and pink line in figure 3 are all travelling in an upward direction, although the turquoise has starte losing a bit of momentum (angle is getting weaker).
We have bounced off the top trend channel and are therefore heading DOWN in terms of the trend channel / quadrant though. Note how this is not confluent with what the H1 chart tells us. The longer term chart needs to steer the view in this instance, unless there is a clear ‘failure’ of the channel to the upside.
That blue line is key also. It is an 8 period moving average, and sets the near term trend and has started travelling down. This and the bounce off the trend channel, plus the fact that we are in quadrant 3 and heading down from quadrant 4 all serve as ‘connected dots’ to suggest that the GBPUSD pair is probably still consolidating.
Figure 3 H4 chart this morning
Figure 4 shows what happened during the news – FOMC economic projections and so on.
Clearly, the message was hawkish (i.e. suggestive of strength in the US economy, thus the dollar, and possibly hinting at an interest rate hike, or clearly, as we will can see by the big red candle, indicating selling of the pound and buying of the US dollar, market participants got that sense of hawkishness and the big players and intraday winners will have traded it).
What was happening on the H4 was a different story to H1, and a more powerful one…
As you can see, that little move into quadrant 3 in the H1 chart, in fact took the market right to the top of the H4 channel, from which a reversal candlestick pattern (shooting star / hammer type) can clearly be seen followed by the sell off right the way through quadrant 4, 3 and 2 and finally into quadrant 1.
But as if to catch unwary traders out, not without a test of the very high of the hammer candle (+1 pip for those who will have been disappointed today by having a terribly tight stop).
Figure 4 H4 chart by this evening
What to perhaps take from all this in terms of technical analysis and possible strategy.
Learning & Strategy (for educational and not advisory purposes).
Check the H1 and H4 for the channel in which the prices appears to be trending currently. Look for confluence, otherwise the H4 should take precedence.
Quadrant trade short: Sell a move from 4–>3 down to 2 or 1.
Quadrant trade long: Buy a move from 1–>2 up to 3 or 4.
Look for a reversal at the top of bottom of a channel.
Hint: For the hammer reversal candle (the candle before the big downmove), rather than entering on the close with a stop just above the candle, wait patiently for a retrace to 40%, 50% or 60% of the hammer candle as a ‘pre-empt’ of the short, giving some room for stops that are too close to the high of the hammer to be hit, e.g. 12 pips above the hammer high.
Entering at the 50% retrace of the hammer at 1.2710 with a 20-30 pip stop (1.2730 or 1.2740) would have allowed a 30, 60, 90, 120 or even 150 pip profit today.
Short term averages like the 8 period simple moving average can give a clue as to the near term trend. Longer term averages, like the 100 and 200 can give an idea of the medium to long term trends.
There was big news today for the dollar. Trading without a stop somewhere (a decent distance depending on risk willingness for the trade, but undoubtedly above the quadrant 1) could have led to a nightmare had the news gone the other way.
I trust this brilliant and yet simple analytical tool taught to me by a long term bank trader of GBPUSD, Jimmy Young, helps traders make more intuitive sense of the trending nature of markets.