Best Reversal Indicators

1. Relative Strength Index (RSI)

Best for identifying overbought/oversold conditions

The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. It is used to identify potential oversold or overbought conditions in a market. The indicator oscillates between 0 and 100 and is typically used with a period of 14, meaning it considers the last 14 trading days.

The calculation of RSI involves first calculating relative strength (RS), which is a ratio of average gain to average loss. The RSI is then calculated using the formula:

RSI = 100 - 100/(1 + RS)

When the RSI reaches extreme readings of above 70, the asset is often considered overbought, suggesting that it may be overpriced and that a downward price correction could soon follow. Conversely, when the RSI reads below 30, the asset is often considered oversold, suggesting that it may be underpriced and that an upward price correction could soon occur.

Note that these thresholds are not strict, and traders may adjust them depending on the volatility of the market. Also, just because an asset reaches an overbought or oversold condition does not necessarily mean a reversal is imminent. Overbought and oversold conditions can persist for a long time, particularly in trending markets.

2. Bollinger Bands

Best for measuring market volatility and detecting overbought/oversold conditions

Bollinger Bands are a technical analysis tool developed by John Bollinger in the 1980s for trading in the financial markets. They are used to measure the market's volatility and provide relative definitions of high and low prices.

Bollinger Bands consist of a middle band and two outer bands. The middle band is a simple moving average, typically a 20-day simple moving average (SMA), and the outer bands are standard deviation lines. The standard deviation measures how spread out the prices are from their average. The default setting for the bands is 2 standard deviations above and below the 20-day SMA.

These bands widen when the market is volatile and contract when the market is less volatile, which provides insight into the market's volatility. They can also be used to identify potential overbought and oversold conditions.

• Overbought: When the price touches or goes above the upper Bollinger Band, the asset might be considered overbought, indicating that the price is relatively high.
• Oversold: Conversely, when the price touches or goes below the lower Bollinger Band, the asset might be considered oversold, indicating that the price is relatively low.

However, when prices hit the upper or lower band, it does not automatically mean a reversal is imminent. Prices can touch or run along Bollinger Bands for extended periods during strong trends.

3. Moving Average Convergence Divergence (MACD)

Best for identifying potential bullish/bearish trend reversals

The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator. It reveals changes in an assets strength, direction, momentum, and duration of a trend.

MACD consists of two lines - the MACD line and the signal line - and a bar chart known as the MACD histogram.

• MACD Line: Calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA.
• Signal Line: A 9-day EMA of the MACD line.
• MACD Histogram: Represents the difference between the MACD line and the signal line.

You can interpret MACD as follows:

• MACD Cross: A bullish signal is given when the MACD line crosses above the signal line, and a bearish signal is given when the MACD line crosses below the signal line.
• Zero-Cross: When the MACD line crosses the zero line, it indicates that the 12-period and 26-period EMAs have crossed. So, if the MACD line crosses above the zero line, it means the 12-period EMA is above the 26-period EMA (bullish crossover), and if it crosses below the zero line, the 12-period EMA is below the 26-period EMA (bearish crossover).

4. Donchain Channels

Best for identifying possible breakouts/breakdowns

Donchian Channels is a technical indicator developed by Richard Donchian, a pioneer in the field of trend following. This indicator is used to understand market volatility and identify potential breakouts or breakdowns. The Donchian Channels consists of three bands:

• Upper Band: This represents the highest price of an asset over a specific number of periods, typically 20.
• Middle Band: This is the average of the upper and lower bands.
• Lower Band: This is the lowest price of an asset over a specific number of periods, typically 20.

The area between the upper and lower bands represents the Donchian Channel.

Traders can use the Donchian Channels in various ways:

• Breakouts/Breakdowns: If the price crosses above the upper band, it could be a signal for a bullish breakout and possibly indicate the start of an upward trend. If the price crosses below the lower band, it indicates a bearish breakdown and could signal the beginning of a downward trend.
• Overbought/Oversold Levels: Some traders may also use the upper and lower bands to identify overbought and oversold conditions. If the price touches or pushes beyond the upper band, it could be considered overbought. Conversely, if it touches or dips below the lower band, it could be considered oversold.

Best Chart Reversal Patterns

1. Head and Shoulders

Best for indicating a potential bearish reversal after a bullish trend

The Head and Shoulders pattern is a chart formation that appears as a baseline with three peaks, where the middle peak is the highest (the head) and the other two peaks (shoulders) are almost of the same height. This pattern is widely used to predict the reversal of a bullish trend.

• Left Shoulder: This forms during a bullish trend. After hitting a new high (the top of the shoulder), there's often a decline to the neckline (a support level), which establishes the beginning of the pattern.
• Head: After the formation of the left shoulder, the price moves up again to create a higher high and then dips back towards the neckline. The peak of the head should be significantly above the peak of the left shoulder.
• Right Shoulder: Following the head, the price moves up again, but this time it creates a lower high (compared to the head) before declining back towards the neckline.

If the price then breaks below the neckline, the pattern is completed, and this is often considered a bearish signal. Traders might then consider opening short positions following this trend reversal.

The inverse head and shoulders pattern signals a potential reversal of a bearish trend, with the head dipping below the neckline and the shoulders above it.

2. Double Top

Best for signaling a potential reversal from a bullish to a bearish trend

The Double Top is a bearish reversal chart pattern that signifies a change in trend from bullish to bearish. This pattern is named so because it consists of two consecutive peaks that are roughly equal, with a moderate trough in-between, suggesting the image of the top part of a rectangular.

• First Top: This is formed during an uptrend when the price reaches a new high and then declines to a level to form a trough.
• Second Top: After the first top, the price increases again but only up to the level of the previous high (or approximately so) before declining again. This inability of the price to create a new higher high is seen as a bearish signal.
• Neckline: The 'neckline' is drawn through the lowest points of the two troughs. The pattern is said to be complete once the price goes below the neckline, indicating a reversal of the initial uptrend.

In theory, the price target after the breakout (the price falling below the neckline) is the distance from the neckline to the top of the peaks, subtracted from the neckline.

3. Triple Top

Best for signaling a reversal from a bullish to a bearish trend. Similar to Double Top but with stronger resistance

The Triple Top is a bearish reversal chart pattern used in technical analysis that is formed from three peaks all approximately at the same level. The pattern signifies that the asset is no longer rallying, and that lower prices are likely to come.

• First Top: This is formed when the bullish momentum pushes the price to a new high followed by a decline.
• Second Top: After the first top, the price rises back to the level of the first peak, showing that there is a strong resistance level. The price then drops back again, forming a trough.
• Third Top: The price increases once more for the third time, but fails to push past the level of the first and second tops, then falls back again.
• Support Line Break: The lowest points of the two troughs form a support level or baseline. The pattern completes when the price breaks down below this baseline, confirming the reversal pattern.

Usually, after the breakout, the price will fall approximately the same distance as the height of the pattern (the high point minus the baseline).

Best Candlestick Reversal Patterns

1. Engulfing

Best for indicating a potential price reversal, either bullish or bearish

The Engulfing pattern is a major reversal pattern in candlestick charting. It comes in two forms: Bullish Engulfing and Bearish Engulfing, each of which signals potential reversals in the price trend.

• Bullish Engulfing: This pattern occurs at the end of a downtrend. The first candle is a small bearish candle, followed by a larger bullish candle. The body of the second candle ‘engulfs’ the body of the first. This suggests that the buyers have overpowered the sellers and a reversal upwards could occur.
• Bearish Engulfing: This pattern appears at the end of an uptrend. It starts with a small bullish candle followed by a large bearish candle. The body of the second candle ‘engulfs’ the body of the first. This suggests that sellers may have taken control from buyers and a downwards reversal may ensue.

2. Hammer

Best as a signal for a potential bullish reversal after a downtrend

The Hammer is a type of candlestick pattern that signals a reversal in price movement. It is typically seen at the bottom of a downtrend and can be a strong signal of a coming bullish movement or upward trend.

A hammer is identified by a small body and a long lower wick, or shadow, which should be at least twice the length of the body. The body can be either bullish (green) or bearish (red), but a bullish body has a more bullish implication.

• In a downtrend, the price opens, then trades significantly lower, but manages to pull up and close near or slightly below the open, creating a small body and long lower wick. This reflects that sellers pushed the price lower, but buyers were able to overcome this selling pressure and closed the session at nearly the same level as the open, suggesting a potential bullish reversal.

3. Doji

Best for signaling market indecision and potential for a change in direction

A Doji is a significant trend-indicating candlestick pattern that appears in the world of technical analysis. It typically represents a state of market indecision and signals that the buyers and the sellers are equally matched, resulting in no net gain or loss in the price.

A Doji candlestick is characterized by its 'cross' formation. It has the same (or almost the same) opening and closing price, resulting in a very small body, often represented by a horizontal line. The upper and lower shadows or wicks of the candle can vary, but they way longer than the body.

There are several variations of the Doji:

• Standard Doji: This has both an upper and lower shadow, which indicates that there was a lot of price movement both upwards and downwards, but the price still closed at or near its opening price.
• Long-legged Doji: This is similar to a standard doji, but with longer upper and lower shadows. This shows a great deal of indecision as price swung broadly back and forth during the period.
• Dragonfly Doji: This doji has a long lower shadow and no upper shadow, suggesting that sellers were initially dominant but buyers managed to push the price back up to the opening price.
• Gravestone Doji: The opposite of a dragonfly doji, a gravestone doji has a long upper shadow and no lower shadow, suggesting that buyers pushed the price up initially but sellers won out, pushing the price back down to the opening price.
• Four-price Doji: This type of Doji is extremely rare, with identical opening, closing, high, and low prices, reflecting an entirely indecisive market. This tends to happen during times of extremely low volume.

4. Inverted Hamme

Best at indicating a potential bullish reversal after a downtrend, with a different formation from the Hammer

The Inverted Hammer is a type of candlestick pattern that often signals a reversal in price trends. It's typically seen at the end of a downtrend and can indicate an upcoming bullish movement or upward trend.

• It has a small body at the lower end of the trading range.
• The upper wick or shadow is typically at least twice as long as the body, while the lower shadow is minimal or non-existent.
• The color of the body can be either green (bullish) or red (bearish), but a green body is generally seen as more bullish.
• During a downtrend, the market opens and starts to trade higher, suggesting an initial bullish momentum. However, the sellers step i and pull the price back down to near the open, but failing to drive the price further down which leaves a long upper shadow. This rejection of higher price levels can indicate that the bulls are starting to step in.

Reversal Indicator and Pattern Strategy Example

A popular strategy using reversal indicators and patterns is the combination of Double Top pattern and RSI (Relative Strength Index).

• Identify a potential Double Top pattern: This pattern consists of two peaks at around the same price level following an uptrend.
• Verify with RSI: Check if the RSI indicates an overbought condition (>70 level) during the first peak of Double Top. And on the formation of the second top, the RSI should show a lower peak indicating a bearish divergence.
• Confirmation: The pattern is confirmed as a Double Top when the price falls below the ‘neckline’ which is the support level in between the two tops. A decrease in volume can also act as a confirmation signal.
• Trade Execution: Once the pattern is confirmed, traders can enter a short position, setting up a stop loss above the last peak.
• Trade Exit: The price target following the pattern can be estimated by measuring the height of the pattern and extending it from the breakout point downward.

This is a simple example of how reversal indicators and patterns can be used together in a trading strategy. More complex strategies might involve more indicators, patterns and considerations like trend and market conditions.

Best Reversal Indicators and Patterns FAQs

1. What are reversal indicators/patterns？

Reversal indicators and patterns in trading are tools or signals, often visual in nature, used to predict possible changes in current price trends. They provide clues about market sentiment and can indicate that the trend is about to change.

Indicators like the Relative Strength Index (RSI), Bollinger Bands, MACD, and Donchian Channels help identify the conditions that might precede a trend reversal.

Patterns also help in the identification of reversals. Chart patterns, like the Head and Shoulders, Double Top, and Triple Top, are visually identifiable shapes formed by price movements over time. Candlestick patterns, like Engulfing, Hammer, Doji, and Inverted Hammer, are specific candle formations that can signal potential reversals.

While these indicators and patterns can help identify potential reversals, they aren't infallible and should be used in combination with other analysis tools and market context.

2. Reversal indicators vs patterns: what's the difference？

Reversal indicators and patterns serve the same purpose – to predict potential trend reversals – but they do it in different ways in technical analysis.

3. How to trade with reversal indicators and patterns？

• Recognize the Indicator or Pattern: You first need to identify the reversal indicators or patterns on the chart. Understanding how each looks and what it signifies is crucial.
• Confirm with Additional Indicators: Don't rely solely on one indicator or pattern. Use other technical analysis tools such as Moving Averages, Stochastic Oscillators, or Volume to confirm the potential reversal signal.
• Wait for Confirmation: Patience is key in trading reversals. Wait for a confirmation like a closing price on the other side of a trendline or another candlestick confirming the reversal pattern before making your move.
• Consider the Market Context: Always take into account the prevailing market conditions. Some indicators and patterns perform better in trending markets, others in ranging markets.
• Practice Risk Management: Always set a stop loss to manage your risk. Its also wise to use other risk management strategies, like not investing more than a certain percentage of your portfolio on a single trade.
• Backtest: Backtesting is a way to verify the effectiveness of an indicator or a pattern before you use it in live trading.

While reversal indicators and patterns can be powerful, no strategy guarantees success 100% of the time. Every analysis has faults and limitations. Therefore, its best to use a combination of tools and techniques when trading.

4. What type of trader needs these indicators and patterns？

5. What is the most profitable reversal indicator and pattern？

The profitability of reversal indicators and patterns varies depending on multiple factors such as the trader's understanding of the indicator or pattern, market conditions, risk management, and trading discipline.

However, both the Head and Shoulders pattern and the Double Top/Bottom pattern are highly recognized for their reliability. In terms of indicators, the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are widely used for detecting potential reversals.

6. What is the best reversal indicator and pattern for beginners？

For beginners, the two most recommended and easier to understand indicators/patterns are:

• Doji Candlestick Pattern: The Doji is a commonly used pattern in the candlestick charts. It‘s easy to spot and can give you valuable insights into the market’s direction. Dojis show a point of market indecision and when used with context, they can be a good signal of potential market reversals.
• Relative Strength Index (RSI): It is an oscillator type indicator that moves between 0 and 100, and it's considered one of the simplest and most effective momentum indicators out there. By simply indicating 'overbought' and 'oversold' levels, it can help predict potential price reversals.

Conclusion

In conclusion, while a thorough understanding of reversal indicators and patterns is not a guaranteed shortcut to success, it can certainly improve your odds in the trading arena. No single indicator or pattern should be used in isolation to make trading decisions. Instead, they should be part of a robust trading strategy that includes risk management, backtesting, and continuous learning. Plus, adopting an indicator or pattern that matches your trading style can greatly enhance your success rate.

WikiFX recommends you educate yourself enough and do more research before starting trading. If you want to trade like a pro, you should educate yourself enough and do more research on brokers that you are interested in before you start trading. Visit our website (https://www.wikifx.com/en) or download the WikiFX APP (https://www.wikifx.com/en/download.html) now to learn more about forex-related information and resources.