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.
Table of Contents
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.