How to recognize a trend reversal

Do you trade along with the trend because you like to ride with the majority of the market? Or are you bold enough to enter the market against the current trend in an effort to maximize its potential? Either way, you’ll definitely benefit from the ability to spot when a trend is ending and starting to reverse.

Trading against the trend is usually not recommended (not only) in forex. Most traders follow the “trend is your friend” rule because trading along with it is considered less psychologically demanding. The duration of the trend may be virtually indefinite and even if the trend lasts for a long time and the currency pair overcomes long-term support and resistance levels, a reversal may not occur. What is expensive can become even more expensive, what is cheap can still be even cheaper.

But the reality is that not everyone can stay in a long-term trend with all its corrections as most traders fail to fully utilize the potential of long-term trends. It’s not recognizing trends that would be the issue here, but rather the psychology of individual traders.

Moreover, many traders and investors enter the trend relatively late. That may not necessarily be always a bad thing, as, during the trend, the pair forms several corrections and consolidations that can be used to make a good entry. However, late entries reduce the profit potential, which is true for both long-term and short-term traders.

Trend reversal – ideal entry with higher risk

The trend reversal approach is based on the assumption that nothing can grow endlessly into the stratosphere, every trend must end at some point. However, recognizing the end or reversal of a trend may not be useful only for the traders who intend to trade against it (knowing when to enter the market), but also for the trend-following traders (knowing when to exit the market). It is actually one of the most important skills that can make trading easier for traders and can increase the consistency of their profitability.

Beware of important fundamentals

In terms of fundamentals, important economic news drives trend changes and can lead to very rapid trend reversals. The problem is that traders usually cannot prepare themselves for these changes in advance, because the strongest trends are often backed by surprising releases or information that can become real market-movers. In any case, traders generally should pay attention to announcements of important news and be prepared to promptly react to them.

As for the technical analysis, there are several methods and tools that can help a trader detect the end or reversal of a trend. Of course, technical analysis is not an exact science, so finding a tool or method that will provide you with 100% accurate results is impossible. Nonetheless, technical analysis is a critical tool for detecting trend reversals.

Avoid pointless, complicated solutions

Traders should also note that there is no need to use complex combinations of different indicators to detect a trend reversal. Such complicated attempts usually result only in overwhelming the chart in a way that the price is barely visible (as we recently described in this article). Indicators are based on the price of the instrument and are therefore inherently belated, which does not make them the most suitable solution for early recognition of a trend reversal.

The most basic trend-identifying tool are trend lines, the breaking of which should lead to a change in trend. Despite being suspiciously simple, this approach can be effective, as shown in the EURUSD example below. As we can tell from the chart, there was a shorter two-week trend that ended with a trendline breakout. Of course, the bounce off the resistance level, and the formation of a lower high (1-2-3 pattern), helped to confirm this, which strengthened the trend change signal. In this particular case, the confluence of multiple factors on the chart resulted in a stronger signal.

As can be seen from the follow-up picture, the incoming downtrend formed on the EURUSD was even longer, but this time, a simple break of the trend line may not be a good signal compared to the first case. Now we are looking just at a stronger correction, after which the trend continues. There was no confluence of multiple factors, and the break of the trend line alone may not be enough to reliably indicate a change in the trend.

Even such a simple task of drawing a trend line may not always be so straightforward, and it certainly requires some level of experience to really make the most of the trend. Let’s see the USDJPY pair for instance, which started to form an interesting trend at the beginning of the year. By early February, it seemed that the trend changes, and a less experienced trader might get the impression that it was time to enter a short trade.

Looking at the same chart a few weeks later, it is quite clear that it was more of a significant correction that did not disrupt the trend at all. Rather, it was a poor plotting of the trend line to suit the current situation and the trader’s willingness to enter the market at any price. The trendline then shows another similar correction, but even in this case, the trend reversal did not occur.

Of course, traders can use other price action patterns and formations such as head and shoulders, double or triple tops and bottoms, triangles, etc. to detect trend reversals. Nonetheless, traders should always take into account the macroeconomic situation in the markets too, and when entering the market, rely rather on multiple factors that all together significantly increase the strength of entry and exit signals.

A trend reversal can be easily confused with a stronger market correction, and as the third example showed us, blindly trying to be always right at all costs is not an appropriate approach when looking for a trend reversal. Thus, in this approach, patience pays more than ever, and not being in a profitable trade is better than being in a losing one.