What Is A Forex Reversal Pattern?
A forex reversal pattern is a price action pattern that signals to a trader that a potential reversal in price is imminent. Typically this is when we see the price of an index, stock, equity or currency pair “reverse” in price going from bullish to bearish, or bearish to bullish as illustrated by the diagram above.
The primary reason why traders like to trade reversals is that they often present the opportunity to make a lot of money in the market if they are able to call the top or bottom of a market. However, this is the most difficult play to execute in the market because prices tend to be manipulated in a way that tricks people into trying to play reversals quite often.
Common Forex Reversal Patterns
In this section we’re going to discuss the various forex reversal patterns that retail traders and supply and demand traders generally look for. As a trader you can use any combination of the patterns listed below, but we highly suggest collecting data and backtesting these patterns so you can see whether or not it’s viable to add them to your own strategy.
Double Top and Double Bottom Patterns
First we have the double top pattern and double bottom pattern which is probably the most common retail reversal pattern that forex, stock, and index traders use to try to call reversals in the market. This reversal pattern isn’t bad, but in our experience at Phantom Trading, they don’t tend to work out as often as one would hope.
Triple Top and Triple Bottom Patterns
Similar to the double top and double bottom patterns, the triple top and triple bottom patterns occur when the price of a trading instrument creates three highs or three lows at close to the same price level. Again, this pattern can work, but what we often see is price getting manipulated in order to grab the orders sitting above these highs before dropping as expected.
Head and Shoulders and Inverse Head and Shoulders Patterns
Next we have the head and shoulders patterns which consist of a “head and shoulders” formation (hence the name) as shown in the diagram above. Again, this is a very common retail trading pattern so it should be approached with caution as price may get manipulated by bigger players in whatever market you’re trading which can result in an otherwise avoidable loss.
Mitigation of A Higher-Timeframe Level of Supply or Demand
The mitigation of an HTF (higher-timeframe) level of supply or demand is pertinent to supply and demand trading strategies such as the strategy we teach at Phantom Trading. When looking for the mitigation of a higher timeframe zone, you’ll want to go to one of the higher relative timeframes such as the 4-hour or daily timeframe to search for a zone of supply or demand that is ideally aligned with the major swing market structure on that respective timeframe. Looking for shorts in pro-trend zones means you’ll stand a better chance of catching a reversal trade that works out in your favor.
Of course, this doesn’t mean you can’t also look for reversal trades by trading off of a counter-trend zone of supply or demand, but the odds of price respecting that zone are overall lower than if you take a trade that is with the higher-timeframe trend.
Liquidity Sweep of A Higher-Timeframe Supply or Demand Zone
Similar to looking for the mitigation of a higher-timeframe supply or demand zone, you can also look to play a sweep of the liquidity resting above the zone (if it’s a supply zone), or a sweep of liquidity sitting below the zone (if it’s a demand zone). By waiting for the zone to get swept (liquidating orders above and below the zone as price crosses through it), you can avoid being stopped out for break-even or a loss, and you can play the bull trap or bear trap that has formed by trading away from the direction that price has swept in.
For example, if price has swept a supply zone’s high, you’d look for shorts after the sweep of liquidity, or if price has swept a demand zone’s low, you’d look for longs after the sweep of liquidity.
Why Forex Reversal Patterns Can Be Risky
The reason why trying to play forex reversal patterns can be risky is because it’s extremely difficult to call the top or bottom of a market. Whether you’re an intraday trader trying to catch an intraday reversal, or a swing trader trying to find a trade to hold, reversals tend to have the highest risk of being stopped out.
This is why you should always approach trying to catch reversals in the market with extreme caution, especially if you’re an inexperienced trader. You stand a much better chance of making consistent profits early on in your trading career by sticking to simple continuation setups rather than trading against the trend.
That’s not to say it isn’t impossible to trade reversals, but there are some ways to approach catching this type of setup that should help you be more accurate and help you to manage your trading risk properly so you can prevent yourself from taking easily avoidable losses.
The other reason why trying to catch reversals can be risky is because most amateur traders who lack experience and time in the markets will encounter fakeouts that happen within price action and may be manipulated into taking positions that will only work out on very rare occasions.
How To Trade Forex Reversal Patterns
As previously mentioned, there are a few different approaches to trading reversal patterns in the forex market, but what we’re going to cover in this article is one of the safest ways to get into a reversal trade setup so you can go “risk-free” on your trade by dragging your stop loss to your entry point to make your trade break-even if it ends up going against you and price continues to rise higher or drop lower (continuation of the existing trend).
1. Wait Until Price Hits A Significant Higher-Timeframe Level of Supply or Demand
As previously mentioned, you can wait until price mitigates (taps into and starts reacting to) a higher-timeframe level of supply or demand first before trying to get involved in a reversal trade setup. You can also look for this in the form of higher-timeframe support or resistance levels. Again, you’re best off taking reversal trades off of higher-timeframe zones on the 4-hour or daily timeframes that are pro-trend so you avoid trading against the trend.
Once price mitigates a higher-timeframe zone of supply or demand, you’d simply wait on your entry timeframe for a “confirmation” trade setup where-in price establishes a shift in orderflow in the direction you want to trade before entering.
2. Wait Until Price Has Grabbed Liquidity Above or Below A Significant HTF Supply or Demand Level
In some cases, you may want to wait until price sweeps the highs or lows of a supply or demand zone before attempting to enter the market and trade a reversal setup because you’ll avoid having your orders swept out of the market yourself. This can be done on any high-timeframe or even mid-timeframe including the 15-minute timeframe.
By waiting for the market to get manipulated you can capitalize on taking a reversal trade by waiting for orderflow to shift after the sweep has occurred, and you’ll have a good chance of at least getting into a position in the market that you can then go breakeven on by trailing your stop loss order.
3. Wait For Orderflow To Shift Before Trying to Enter
As previously mentioned, waiting for a shift in orderflow (also known as a break of internal structure) on the mid-lower timeframes will keep you out of a lot of avoidable losses. Rather than trying to “catch a falling knife”, you simply wait for orderflow to shift indicating that either supply is in control when looking for short sell reversal setups, or an orderflow shift indicating that demand is in control when looking for longs in a bearish to bullish setup.
4. Look For Signs of Price Exhaustion / Price Capitulation
Last but not least, we have capitulation, which is when price shows potential signs of being exhausted. Again, this is a reversal pattern that you can use either in bullish or bearish scenarios where you’re seeing signs that a bullish run or a bearish sell-off in the market is starting to lose steam.
Using price exhaustion as well as the other aforementioned tips as combined confluences in the market can make for trade setups that have a very high probability of playing out in your favor. Again, this is based on our own testing and experience in the live markets, but regardless, we urge you to test these concepts on your own and to decide for yourself!
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Robert Castillo
@coldwaterfx
FX Trader & Analyst
Writer & Editor
Rob is a funded trader from Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading, he enjoys making music, boxing, and riding motorcycles.
