Trend reversal point on Forex

2024.09.13 2024.09.13 Trend reversal point on Forex

Oleg Tkachenkohttps://www.litefinance.org/blog/authors/oleg-tkachenko/

Trend trading is one of the most common strategies among novice traders. Its difficulty is determining the moment of a potential reversal, before which the trader must close the position or, vice versa, immediately enter the market at the beginning of a new trend. A trader should understand that this is a reversal, not a correction, and they can use tools such as reversal indicators, divergence, patterns or pivot points. In this review you will learn how to use these tools and what their advantages and disadvantages are.

How to predict a trend reversal: overview of analysis tools

What could be simpler and more effective than trend trading? It would seem that you just need to encounter a strong movement, stock up on capital to withstand small local reversals and watch the deposit grow. But in practice you are sure to stumble upon several questions:

• How do I know whether a price reversal against the main trend is a local correction or a new opposite trend?
• How to predict the moment when the strength of the trend runs out and the price line reverses?
• How to calculate the resistance and support levels at which a reversal signal or, on the contrary, a trend continuation signal can appear?

I will try to answer all these questions in this review by introducing the basic tools for determining potential trend reversal points. Some things are from personal experience, others from trading forums and blogs. I welcome any criticism and comments in the comment section of the review.

Trend reversal point forecasting tools

A strong trend is a significant market dominance of either sellers (a growing trend) or buyers (a falling trend). At some point, the number of traders of the prevailing party and the volume of their positions are reduced, the price slows down until the moment of equilibrium. At that moment, when the weaker side turns into the stronger side, a reversal occurs. The trader’s goal is to predict and use this moment for their own purposes.

The following tools exist for determining the price reversal point:

• Technical analysis indicators.
• Divergence.
• Trend reversal patterns.
• Levels (resistance and support, Fibonacci).
• Pivot points.

Let us consider these tools in more detail.

1. Technical analysis reversal indicators

There are hundreds of reversal indicators and each of them works according to its own principle. I will not analyze examples in detail, I will only describe groups of such indicators in general terms:

• Oscillators. Reversal indicators that identify overbought and oversold zones. If the oscillator is in the overbought zone, it reverses and prepares to exit it, then we can talk about a potential change in the direction of the current trend. It is important that the indicator exits the zone at as close as possible to a 90° angle with respect to the horizontal border of the zone. Examples: Stochastic, RSI, DeMarker.
• Channel indicators. In theory, the price aims to reach its equilibrium value, i.e. the state of balance between supply and demand. When it moves away from its average value, the balance is violated, but sooner or later, the price comes back again. The amplitude of price fluctuations forms a channel, and most often reversals occur at the borders of this channel. Examples of such indicators: Bollinger Bands, Donchian Channel.
• Classic simple indicators with different periods. Most often, moving averages (simple, exponential), stochastics, etc. are used. Determining the pivot point is basically waiting for the moment when all the lines converge together, after which the trend will reverse and the indicators will diverge. Examples of such strategies with Stochastics (Spud’s thread), MA, Alligator and Anti-Alligator are described in this review.

Remember that indicators are just algorithms built on a particular mathematical formula. They have many shortcomings: they lag and do not take into account the fast-changing character of the market situation, i.e. the illogical actions of big capital owners. They are constantly improved, various smoothing models are used, but this does not significantly affect the signal performance. Therefore, be careful when relying on the signals of reversal indicators: double-check them on other timeframes, compare with the data of other tools - in a word, do not be afraid to experiment. Finding an accurate trend reversal indicator is not so easy.

2. Divergence

Divergence is the discrepancy between the technical indicator and price direction. In other words, the indicator shows that the market is overbought and moves down from the signal zone, while the price, on the contrary, continues to grow. The reason is that the indicator leading and the price is inert, so it reverses immediately after the indicator. Divergence is an additional but stronger signal that predicts a reversal. All that is left is to notice it in the chart. This is not always easy though.

The most common strategy described on many forums is the search for divergence using RSI, MACD and slow stochastics. But there is an opinion that RSI is not suitable for finding discrepancies, so you will have to try yourself.

• Question to professional traders working with divergence: what indicator would you recommend, and what are the optimal settings and timeframe?

Read more about divergence in the following review:

• What is Divergence on Forex. This is an extended review explaining how to build divergence lines, how to find it in the chart, and what the most common mistakes are.

Divergence is not for everyone as too many nuances must be taken into account that can otherwise lead to an error. You should only use it in a live account when you have a trained eye to see it instantly. If you still need to build lines and double-check everything, perfect your skills on a demo account.

However, you can go the simpler way: why draw lines if you can use ready-made combined tools? One of the most popular indicators in trading circles is the Divergence Panel. You can download it here, installation is standard (if you need help, leave a comment below).

Divergence Panel is an information panel with buy and sell signals for all currency pairs and timeframes. In the archive downloaded from the link above you will see another file - Divergence Solution. It is a modified MACD without an additional moving average. Divergence Panel was created based on it. These two indicators are pretty much the same, the only difference is in the output format. I would use the Divergence Panel as the main divergence indicator, but you should open Divergence Solution too.

The indicator is interesting in that it analyzes all the standard timeframes of the main currency pairs. Its settings allow you to analyze any combination of pairs and timeframes. The indicator has more than 20 settings, so it is better to leave them unchanged for testing. They are for ZigZag, RSI, EMA and ATR indicators, which are also in the Divergence Panel.

Features of the Divergence Panel:

• In addition to entry points, the indicator gives recommendations on setting Stop Loss and Take Profit.
• In the indicator panel, you can set the required currency pair and timeframe in the Chart window.
• In the chart, the indicator draws lines of confirmation of divergence, highlights the signal area and shows the recommended entry points with arrows.

False signals are quite common, but this is only if you follow the recommendations of the indicator blindly. For example, the last recommendation for a short position with a stop loss at 0.8 and take profit at 0.29 seems more than strange. However, the trend direction after the indicated entry point in both cases really turned out to be true, although small.

It all depends on the goals. If you do not use leverage and set long stop orders, then, for example, the first signal could have given you an opportunity to earn not only on the first short upward movement (the first 20 candles), but also the long one (close the long position at the moment the second downward signal appears).

Here in the screenshot you can see the chart after the second signal. Divergence really worked, but only in the short term. While in the previous case after the first signal we could leave the position for several days, here it must be closed at the level marked with the yellow line.

Signals are not frequent - sometimes you have to wait several days in the M15 interval, but this is better than nothing. I recommend not to focus on the proposed levels for placing orders and close the positions earlier without leaving them on their own.

Also pay attention to the convergence angles of the indicator lines. The more the lines in the price chart and in the Divergence Solution are directed towards each other, the stronger the signal. For example, in the first screenshot above, the signals are weak: in the first case, the line in the price chart is almost horizontal, in the second - the line in the indicator is almost horizontal. Therefore, the price movement after the reversal is weak.

• Conclusion. The Divergence Panel is really good at tracking divergence and showing precise entry points. But do not pay attention to its recommendations for placing orders. Also do not chase long-term profit - open a position in the direction of the arrow, wait for 10-15 points of profit, move the stop loss to the breakeven level, add a trailing stop and close the entire position at the first hint of a reversal.

There are other divergence indicators. For example, modified versions of MACD and Stochastic with divergence formula added or Divergence Viewer, a complex indicator built on RSI, RVI, MACD, Momentum, Stochastic, Standard Deviation indicator or a couple original indicators, or FXDivergence. These are not for everyone. Although they give frequent signals, I like the Divergence Panel more in terms of performance. If you disagree, we can discuss this in the comments.

3. Trend reversal patterns

A pattern is an often repeating figure in technical candlestick analysis predicting further trend behavior. If you are not familiar with this concept, be sure to read this article, which describes the main patterns. Here I will elaborate on determining reversal levels using this method.

Issues with practical application of patterns:

• When a trader sees a formed pattern, sometimes it is already too late to make the decision. For example, the classic Head and Shoulders pattern, where the trader needs to wait until the formation of the second half of the pattern to recognize it, but the right moment of opening a position has already been missed by then.
• The concept of patterns is based on the constancy of the formation of the same figure, but the market is chaotic. Emotions and big capital of market makers rule here, and any pattern can turn into a meaningless set of consecutive candles in mere seconds.
• If you find a perfectly formed pattern in the chart (as it is drawn in textbooks), please send me a screenshot. There are almost no perfect patterns. It will long before you learn to quickly identify a particular pattern.

Patterns are more of an auxiliary tool supplementing the construction of levels and data of technical indicators. Seeing them is a cool skill, so if you can do that, you can consider yourself a professional.

Remember that people often give in to wishful thinking. If you want to see a pattern confirming the reversal and change in price, you will see it. The problem here is psychological. The appearance of a technical analysis pattern does not necessarily mean a trend reversal or its continuation. A pattern only increases the probability of the event, but does not guarantee it actually happening.

4. Resistance and support levels

This is probably one of the easiest ways to identify potential reversal points. The construction of levels is based on psychology and stereotypes. For example, many traders like round numbers for some reason. And when an accumulation of stops or take profits is formed at some round number level, a strong resistance and support level appears, which in the future again will be perceived by traders as a key level.

If you are not familiar with these tools, check out the following article:

• Why levels form. The article explains how local levels form taking into account the psychology of traders and with simple examples.

Another interesting tool is the Fibonacci calculator. The rules for constructing levels depend on their type, but why complicate your life if there are ready-made tools for this? Enter in the calculator the high and low price value of the trend segment under consideration and get the absolute price values ​​in accordance with the Fibonacci percentage levels.

If you are interested in indicators for building levels, leave a comment and I will tell about some of them in a separate review.

5. Pivot points

Pivot points are classic reversal points located between three levels of resistance and support, in which the Forex market mood is most likely to change (from bullish to bearish and vice versa). Calculation formula:

• Pivot = (High (H) + Low (L) + Close (C)) / 3, i.e. add the high, low and closing prices. The result is divided by 3.
• R1 (Resistance) = Pivot + (Pivot - L)
• R2 = Pivot + (H - L)
• R3 = High + 2*( Pivot - L)
• S1 (Support) = Pivot - (H - Pivot)
• S2 = Pivot - (H - L)
• S3 = L - 2*(H - Pivot)

The first levels in terms of the likelihood of a reversal are R1 and S1. If the price passes them, the next levels are 2 and 3, respectively. The Pivot point itself is the average position of the price, from which the price goes either to R1 or to S1. You do not need to calculate them manually - analytic resources already have ready-made tables where the data are calculated for all currency pairs with time intervals.

Here is an example of such a table built for an hourly interval. You can also use the pivot point calculator. Fill in the data for the three points used in the formula and you will get the result.

In addition to the classic Pivot points, there are also other points:

1. Fibonacci. These are the same Fibonacci levels, so the formula is the same as well.

2. Camarilla. Here, 4 levels are calculated instead of 3. Why the author took such coefficients is a rhetorical question, but stop loss and take profit orders are most often set on these levels. Calculation formula:

• R4 = (H - L)*1,1/2 + C
• R3 = (H - L)*1,1/4 + C
• R2 = (H - L)*1,1/6 + C
• R1 = (H - L)*1,1/12 + C
• S1 = C - (H - L)*1,1/12
• S2 = C - (H - L)*1,1/6
• S3 = C - (H - L)*1,1/4
• S4 = C - (H - L)*1,1/2

3. Woody. The difference from the classic version is that the weight of the closing price candle is doubled. Calculation formula:

• Pivot = (H + L + 2 *C) /4. 
• R1 = 2*Pivot - L
• R2 = Pivot + H - L
• S1 = 2* Pivot - H
• S2 = Pivot - H + L

4. DeMarker. Calculation formula:

• If the closing price is less than the opening price, then Pivot = H + 2 * L + C
• If the closing price is greater than the opening price, then Pivot = 2 * H + L + C
• If the closing price is equal to the opening price, then Pivot = H + L + 2 * C
• S1 = Pivot/2 - L
• R1 = Pivot/2 + H

There is no indicator in MT4 building Pivot levels according to one or another scheme. So you need to download, install it and do experiments.

The idea of ​​calculating Pivot points is somewhat similar to MA. The formulas differ by the weight of one or another price. There are no ideal formulas, because it is only up to you to decide which points you will use. The tool is auxiliary and can work in certain local situations for certain pairs. Remember that this is just a mathematical algorithm that does not take into account any fundamental factors.

In order to work with the tool, the trader needs to know the average volatility for the required period (it can be found on analytical resources) and the direction of the trend. If the price is above the Pivot point, it makes sense to bet on a long position, taking into account the fact that the price can turn around at the R1 level. If the reversal has not occurred, the target level is R2. If the position is open at the R1 level, then R2 and R3 are the target for closing the position. However, how you use the Pivot levels is entirely up to you.

In the trading manuals, there is one more sign of an approaching reversal - a slowdown in trend movement. The slowdown is a transition to horizontal movement, a decrease in amplitude, etc. – i.e. a decrease in the activity of traders and trading volumes. This deceleration is visible in the figure below due to the increasingly horizontal lines.

Here we have several controversial issues. First, the decrease in volumes may be caused by other reasons (expectation of news, seasonality, change of sessions). Second, the slowdown often goes into a flat. But the direction of the trend after the flat is much more difficult to predict (here you should add fundamental analysis).

After 2 rises and two decelerations, the reversal did not happen. Should you rely on slowdown? You decide.

Finally, a few tips for novice traders:

• Do not rush to jump into the last car of the departing train. If the price is gaining momentum, there is no need to rush to open a position in its direction. It may be that serious players are just waiting for the lemmings to enter the market almost at the high to push them out with their large volumes in the opposite direction. Professional traders enter the market at the beginning of the trend and exit when the lemmings raise the price in an effort to get some easy money.
• Try to use several instruments at the same time to predict trend reversal points. But do not be surprised if they all give different information. Deal with one, then move on to the other.
• Take your time when deciding to drop the instrument. Perhaps you have chosen the wrong timeframe, the wrong asset, or simply haven’t figured out some quirk.
• Do not use reversal tools blindly. First, develop a trading strategy, work out a risk management system. You must understand the error margin you can withstand for a given lot size and leverage if the reversal point is in another place or the reversal turns out to be a correction. Learn how to calculate the lot volume here.
• Keep in mind that a trend reversal may occur suddenly under pressure from big capital owners. In other words, the reversal is not always preceded by a slowdown in the price chart.
• Use multiple timeframes for analysis.

Conclusion. There is a multitude of tools for predicting trend reversal points, but none of them are perfect. The attempt to combine them can further confuse you and lead to negative results. Remember that the behavior of financial markets can never be predicted 100%. And if Forex indicators do not live up to expectations, it means either you have configured them incorrectly or have not yet learned to use them properly.

If you have any problems with the above tools, be sure to mention it in the comments. LiteFinance has a team of professional traders and analysts who are always happy to share their knowledge with beginners. Feel free to ask questions, let's succeed together!

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Price chart of EURUSD in real time mode