What is Reversal Trading?

What is Reversal Trading Strategy?

In reversal trading, traders aim to capitalise on shifts in market momentum. Traders identify potential peaks and troughs using historical data and enter/exit trades to leverage reversals in asset price. It is essentially a contrarian strategy where traders earn profit by taking a position opposite to the current market trend.

Traders identify signs of a potential reversal by looking at patterns on price charts and using various technical analysis tools. Common indicators for identifying reversal trading patterns include moving averages, Relative Strength Index (RSI), Stochastic Oscillator and Fibonacci Retracements. Traders look for overbought/oversold trends, momentum, divergence between price and volume, etc., to anticipate reversals. 

To understand reversal trading, let’s take the example of stock A, which has been on a bull run for four days. If you anticipate that the stock price will fall on the fifth day, you can take a short position based on technical analysis. 

Different Ways to Spot Market Reversals 

Traders use the following tools and methods to identify signs of a possible reversal:

• Price Action 

Price action trading involves monitoring price movements on the charts over time. Sudden breaks in resistance and support levels on charts indicate signs of an upcoming reversal, especially if it is accompanied by an increase in volume. 

• Candlestick Patterns

Traders can spot signs of potential reversal visually from certain candlestick formations, including hammer and Doji patterns. A hammer pattern at the end of a trend indicates a potential bullish reversal, while a Doji after a long trend indicates indecisiveness and reversal. Traders can also identify if an upcoming trend is weak or strong.   

• Technical Indicators 

Technical indicators, such as Moving Average Convergence Divergence (MACD), RSI and Stochastic Oscillator, help to identify trend reversals. Many traders use these tools with price action to confirm their predictions. RSI measures both the speed and the direction of price movements, while MACD helps spot reversals from divergences. 

• Volume Analysis 

An increase in volume at resistance and support levels indicates strong buying and selling pressures. In reversal trading, traders look at volumes to confirm if a price movement will be sustained.

Common Reversal Trading Patterns

Here are some common reversal patterns you should learn to identify:

• Head and Shoulder

This candlestick pattern consists of three peaks, where the first and third peaks are called shoulders, while the second peak is called the head. The line connecting the first two troughs is called the neckline. It is a bearish trend reversal pattern that tells traders to take short positions and exit long positions.

• Double Top 

The Double Top forms following a bullish trend. It consists of two peaks that form at around the same level when the stock price reaches a high twice, forming a figure M. It is a bearish reversal trading pattern and a strong signal.

• Double Bottom

This is the opposite pattern to Double Top, where two troughs form at around the same level, following a bearish trend. The pattern looks like the alphabet ‘W’. The resistance level between the two troughs forms the critical level. Traders typically take a long position when they confirm this pattern. 

• Triple Top and Bottoms  

This pattern has three peaks or troughs at the same level following an uptrend or a downtrend. Each peak or through is usually smaller than the last. It confirms a bearish or bullish reversal trading pattern, encouraging traders to take a short or long position. 

• Sushi Roll Reversal Pattern

A Sushi Roll is a candlestick pattern that has 10 bars that form the pattern of a literal 'sushi roll'. The first five bars, called inside bars, have a narrow range of highs and lows, while the outside bars have lower lows and higher highs than the first ones. This pattern is observed during a dominant trend and signals a potential trend reversal. 

• Inverse Head and Shoulder

This is essentially the opposite pattern of head and shoulder with three distinct troughs instead of peaks. Here, the original trend is bearish, and the pattern confirms a reversal once the breakout is confirmed. 

Final Thoughts

Traders look for signs of potential reversals to benefit from large price swings or move out of unfavourable positions. Reversal trading requires people to have a good understanding of reversal chart patterns, candlesticks and technical analysis tools. However, most reversal trading strategies carry very high risks, and false signals can result in massive losses. 

Disclaimer: This content is solely for educational purposes. The securities/investments quoted here are not recommendatory.