Introduction
Whether it is forex, crypto, metals, stocks, or options, traders are looking to ride trends. Trend-following is sticking to the most dominant force in any market.
Even the legendary Jesse Livermore once said, “Successful traders always follow the line of least resistance. Follow the trend. The trend is your friend.”
However, Ed Seykota has said, “The trend is your friend until the end when it bends.” This is where candle reversal patterns come into the picture.
Although it is necessary to spot a trend, it’s equally crucial to identify when it is about to finish. Fortunately, we have many forex reversal candlestick patterns to exploit. Without further ado, let’s take a look.
(Side note: We covered overall chart patterns here if you’re interested, looking at trend continuations and reversals.)
What are reversal patterns?
A reversal pattern is any chart formation that signals the likelihood of the price moving in a counter direction to a trend. It is generally much harder to trade reversals than to stick with the trend.
Think of it like trying to stop a moving train. Trends have the strongest momentum behind them, meaning they are stubborn in changing direction. Also, it is sometimes challenging to tell whether a trend retracement will become something more.
Yet, through intricate formations, we can get early clues. We primarily have two types of reversal set-ups: chart reversal patterns and candlestick reversal patterns.
Chart-based formations are more reliable because they take longer to form, offering greater market context.
Forex candlestick reversal patterns consist of a uniquely-shaped, individual candle or a series of 2-3 candles. Because these can form anywhere, you need more confirmation when trading them.
Best chart reversal patterns
Let’s look at the top chart-based reversal formations with real examples and entry parameters.
Head and shoulders
The head and shoulders reversal pattern is a fan favourite. It’s an interesting formation consisting of several parts. As you may have guessed, the name comes from how the set-up resembles the human head and shoulders.
This reversal pattern consists of three successive peaks, where the central peak (or the ‘head’) is higher than the other peaks of relatively the same height. A ‘neckline’ or breakout resistance zone connects these swing highs.
Of course, an inverse version of the head and shoulders exists, where everything is the opposite.
Entry point: once the price breaks the neckline
Stop loss: at the highest shoulder
Profit target: distance from the head to the neckline
The chart below shows this reversal pattern in better detail. Here, we have marked the entry point (including a secret entry technique) and other parameters.
Wedges
These are reversal patterns that look like triangles. With wedges the price converges between two diagonal lines. The result is a thinner, cone-like triangular shape.
Traders use wedges as continuation and reversal patterns. We have a rising wedge, signalling a bearish reversal, and a falling wedge, suggesting a bullish reversal.
Ensure that you connect at least swing highs/lows when drawing wedges. Here are the trading parameters below.
Entry point: once the price breaks out of the trend line
Stop loss: below/above the nearest swing low/high
Profit target: the height of the wedge
Let’s look at a real chart example of a falling wedge.
Double bottoms and double tops
Double bottoms and double tops are reversal candlesticks with a similar structure to the head and shoulders (but without the head). The formation consists of two consecutive swing highs/lows of equal depth.
Each of these reach a particular support (for double bottoms) or resistance level (for double tops). The price will move in the opposite direction to break the ‘neckline,’ the entry point of this set-up.
A simple way to remember these reversal patterns is that the double bottom is shaped like a W, while the double top is shaped like an M.
Entry point: once the price breaks out of the neckline
Stop loss: below/above the nearest swing low/high
Profit target: the distance from the swing/low to the neckline.
Like head and shoulders reversal patterns, you can use an alternative entry technique. Once the market has broken out of the neckline, some traders wait for a 50% Fibonacci retracement. This allows for a better entry, meaning more pips in profit.
Below is a picture of this set-up in action.
Best reversal candlestick reversal patterns
As briefly mentioned, it’s always best to combine forex reversal candlestick patterns with something else. Here, we’re referring to confluence or elements that align with these formations on the chart; the more, the better.
For instance, this can be:
- Support/resistance zone
- Pivot point
- Psychological level (or round number)
- Moving average
- Divergence from an indicator
- Any of the reversal patterns already mentioned
Also, another tip is to trade on higher time frames (from the H4 chart) for the best chance of success.
Pin bars
A pin bar is an intriguing reversal candlestick formation with a pin-like appearance that has a long wick and a small body. The wick stands out and makes up at least 75% of the candle. So, how does it form?
The pin bar is a classic example of rejection. During its formation, the candle appears like a regular full-bodied bullish or bearish candle. However, the price eventually moves sharply in the other direction, with the close near the open.
This is what gives it a strikingly long wick and petite body.
The example below will look at the pin bar reverse candlestick on a real chart, along with two confluent elements. Here, we are looking at the daily chart of CAD/JPY, where we see a nice bullish pin bar at an obvious support level.
Also, a bullish divergence formed on the RSI, offering a second confirmation factor. Generally, traders enter pin bar reversal patterns by waiting for the candle to close. It’s crucial to enter after the set-up has formed completely to prevent a false signal. As with the other formations, you can wait for a 50% Fib entry if you missed the first entry.
The stop loss would go beneath the low. There is no set profit target for the pin bar. Yet, experts recommend aiming for a 2:1 risk to reward.
Engulfing candles
Engulfing candlestick reversals consist of a bullish/bearish candle followed by another of a much larger size closing in the opposite direction. The second candle is said to ‘engulf’ the previous, suggesting that one group of participants has become more prominent than the other.
The image below shows the bullish and bearish versions of this reversal pattern.
Of course, bullish candlestick reversals happen during downtrends, while bearish candlestick reversals occur during uptrends.
Let’s explore this pattern in a real-life setting below. We see an excellent bearish engulfing set-up on a clear daily resistance zone (orange rectangle). Here, the stop loss would go above the high. As with the last example, aim for a minimum of 2:1 profit.
Conclusion
Although trading reversal patterns is considered riskier than trend trading, they offer higher profit potential. This is because you are entering at the earliest stage of the move in a pair. You know what they say: the early bird catches the worm.
Remember, always use a stop loss for effective money management because these patterns aren’t foolproof.
