What is trend reversal in trading?
A trend reversal marks the end of an existing trend and the beginning of a new one. A reversal may happen in any timeframe and can mean the difference between a big win, a break-even, or a loss. Being able to effectively spot a reversal is the fastest way to “jump” on a new trade. As we have seen in previous videos, a trend is the direction of successive tops and successive bottoms.
An example of a popular reversal is the Head and Shoulders. The Head and Shoulders reversal is formed at the end of an uptrend. The highest top is the Head. The top to the left of the Head is the Left Shoulder and on the right is the Right Shoulder. The line that connects the last two bottoms is known as the neckline, which acts as support. A break below the neckline forms the reversal pattern of Head and Shoulders that marks the end of the uptrend and the beginning of a downtrend. We’ve got one more Technical Analysis Basics video in store for you – see you then!
Another well-known trend reversal pattern is the Double Top or Double Bottom. Like the Head and Shoulders reversal pattern, these can take place in any market and time frame. A Double Top is a bearish reversal signal after two tops have formed, with a modest declin in between them. It is shaped like an "m" and is confirmed once price falls below support. This is equal to the low between the two previous tops.
A double bottom forms a "w" pattern of two bottoms, where the second bottom does not go lower than the first. The top found between the two bottoms acts as resistance and the reversal is confirmed if this resistance breaks. This is a bullish reversal pattern suggesting the end of a downtrend and the start of an uptrend.
There are many other reversal patterns such as a rounding bottom and a rising or falling wedge. They all point to a trend change and can be used on all time intervals and markets.
How do you trade trend reversals?
This depends on what type of reversal pattern you have identified, but let's take the Head and Shoulders. Traders will place an order below the neckline and look for a move down in the event of the uptrend reversing. You can calculate a target by measuring the top of the head to the neckline.
What is a trend following trading strategy?
Traders can use a variety of ways to see if price is changing its trend. This includes drawing trend lines between at least two points on a chart. The more points connected, the stronger the trend - so when this is broken, a reversal may be in play. Traders also use fibonacci retracement levels and pivot points.
It's important to remember that trends do simply retrace. This is a temporary price move which is more short-term and where the fundamentals do not change.
We've got one more Technical Analysis Basics video in store for you - see you then!
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