Be Careful With the Reversal Trade Setups
You read everywhere that trend is your friend and you should not go against it. This is so true. However, any trend will end finally. It either reverses or goes sideways. As the markets trend only 30% of the time, it is good to take the advantage of the reversal setups and also the ranging and sideways markets.
Sometimes trends are continued for such a long time, specially on the currency market. If so, you can ride the trend and take the continuation trade setups. But sometimes the reversal setups are so profitable as well.
The point is that the reversal setups are usually riskier to take because it is risky to go against the strong trends. However, you can filter out the false reversal setups by following some simple rules.
The first rule is that you should not take the the reversal setups when the trend is still strong and there is a fresh movement right before the reversal setup forms.
There is no doubt that a strong movement cannot be continued forever and the party that has taken the control will get exhausted and wants to stop somewhere. It means a portion of them want to close their positions to collect their profit, and the others stop adding to their positions. So the movement becomes weak after a while and then stops, and the market will go sideways.
While the movement is still strong, some reversal setups form. Those are the ones that you should avoid, because most probably the movement will be continued after such reversal setups. Here is some good examples.
At the left side of the below chart, you see s strong and continued uptrend. While the price is going up continuously, some reversal setups form. Those are the ones the you have to avoid, because they form right after a strong up movement.
As the left side of the chart, you see a too strong down movement. But even in case of such a strong down movement, some reversal setups form. Those are the ones that you have to avoid strictly because they are too risk to take.
The red arrows show the reversal trade setups that you have to avoid and the green arrows show the strong movements that had been formed right before the reversal setups. Indeed, the green arrows are the reasons of avoiding the setups that the red arrows have marked:
The second rule is that you should take the reversal setups only when you are sure that the trend is completely exhausted and ended.
Although still there is no guarantee that the trend not to be continued, at least you will have the chance of moving your stop loss to breakeven or getting out before it becomes too late because the market will follow the reversal setup for a while before it continues the trend.
The reversal short trade setup that was formed by 2014.05.08 daily candlestick on EUR/USD daily chart, is a good example. It is formed where the bullish market has become completely exhausted and almost sideways (see the below chart.)
The green arrows show that bulls became exhausted and weaker as the time goes by. While the market becomes almost sideways (the yellow zone), a strong Bearish Engulfing forms by 2014.05.08 daily candlestick and then a support breakout forms that I call it “reliable” support breakout in this case because it is formed at the right place right time:
The rule number three is that the reversal setup has to be too strong, otherwise you have to avoid it.
You can see this on the above example. The reversal trade setup that was formed by 2014.05.08 candlestick is really strong. That is why the market formed a strong downtrend after that.
There is no doubt that traders cannot take all the movements and ups and downs. They are either late or hesitant in some cases. But being late or hesitant is better than taking the wrong setups.
To be at the safe side, you can wait for the markets to trend, and then you take the continuation setups, in case you think the reversal setups are too risky to take.
Good luck 🙂