A reversal occurs when a currency pair changes direction after following a trend. Instead of continuing in the same direction, the price shifts and starts moving the opposite way.

After an uptrend, a reversal would be a change to a downward trend (also known as a ‘bearish reversal’).

Conversely, after a downtrend, a reversal would be a change to an upward trend (also known as a ‘bullish reversal’).

Example of a Reversal:

Take, for instance, the EUR/USD exchange rate.

Assume that the pair reaches a high of 1.2000, then begins to decline, reaching a low of 1.1800, following a prolonged period of an upward trend (or rally). This could be an indication of a bearish reversal.

This could be seen by forex traders as an indication that a new downward trend (bearish sentiment) is beginning and that the previous upward trend (bullish sentiment) in EUR/USD is waning.

In order to prevent losses in the event that the price keeps declining, traders who had been purchasing the pair (going long on) may choose to sell off their positions.

Conversely, traders who prefer to follow trends may begin selling (going short on) the pair in an attempt to capitalise on what they believe to be an impending downward trend.

How to Identify a Reversal

Spotting a reversal requires analyzing price action, technical indicators, and market sentiment. Traders use a variety of tools and indicators to identify potential reversals, and some of these include technical analysis indicators like moving averages and oscillators. Others includes:

Trendline Breaks:
A trendline break indicates that the previous trend is losing strength.

Support and Resistance Levels:
If the price fails to break through resistance or support, it may reverse direction.

Candlestick Patterns:
Patterns like Doji, Engulfing, or Head and Shoulders suggest a trend reversal.

Moving Averages:
When a short-term moving average crosses a long-term one (e.g., 50-day MA crosses below 200-day MA), a reversal may occur.

Momentum Indicators:
RSI (Relative Strength Index) or MACD (moving average convergence divergence) can help confirm reversals.

Traders also look for specific chart patterns that often precede reversals, such as ‘head and shoulders,’ ‘double top,’ or ‘double bottom‘ patterns.

Conclusion

Recognizing reversals in forex trading can give traders a strong edge in the market. By using technical analysis, candlestick patterns, and momentum indicators, traders can improve their ability to spot and trade reversals. Always practice on a demo account before applying these strategies in real markets.

Related Term

Divergence