Part 11 Technical Analysis – Confirming reversal using indicators

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Part 11: Technical Analysis – Confirming reversal using indicators

Now that you’ve come all the way to the part 11 of our technical analysis series, I assume that you’ve studied all the previous ones. If not, I recommend you to have a look – it’s all very important and every intraday trader should know about them.

We’ve already talked about support, resistance, trend line and fibonacci lines. That’s already a whole bunch of tools that you could use for trading, isn’t it? However, what you don’t know yet is that you’re still missing the most important thing – how to know whether the price will bounce off the line instead of breaking through it? In Part 8: Technical analysis show – The breakouts, we have talked about the complete opposite and that is how to confirm that the price has broken out.

There are 3 basic types of reversals:

  • The reversal with the trend where you can go along with it
  • The reversal against the trend that is recommended only for the advanced traders
  • The reversal with the stagnating trend that could be used with the short-term options

3 basic types of reversals

How to recognize and confirm a reversal

To realize that the reversal could happen is really easy. All you need to do is to draw in a right way the important price lines and the moment the price will come close to approx. 10 pips it could go right back whenever, in this case the reversal could happen.

To do so in the right way, to find out whether the reversal was real and not only a false alarm is not an easy thing. That’s why we need to learn to recognize the false reversals, so we don’t have unnecessary losses and the sooner we do, the better. We can recognize the reversals by two basic methods – using indicators or price action and using both methods together is the best.

Indicators method

The bounces can be seen very nicely using oscillators, such as stochastic oscillator or DSS Bressert, but also indicators such as ADX or by simply showing Volume.

  • Simple method using STOCHASTIC
  • the oscivator breaks 80 or 20 lines inwards

A simple use of stochastic oscillator

  • Simple method using VOLUME IN THE GRAPH

– Volume is decreasing – > we could assume a real reversal

A simple use of volume

  • Simple use of ADX Indicators
    • If the main ADX curve is coming towards the line 50 we could soon await a reversal against the trend (it’s usually a short term reversal before continuing in the previous direction)

A simple use of ADX indicator

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Price action method

You’ll find out how to confirm reversals using price action soon, in one of the following technical analysis series (Here: Part 12: Technical Analysis – Confirming price action reversals) Are you looking forward to it? Show it to your friends and share this article on Facebook!

Author

More about the author Step

I’ve wanted to build a business of some kind and earn money since I was in middle school. I wasn’t very successful though until my senior year in highschool, when I finally started to think about doing online business. Nowadays I profitably trade binary options full-time and thus gladly share my experiences with you. More posts by this author

4 Responses to “Part 11: Technical Analysis – Confirming reversal using indicators”

This is really helpful thanks but i have a question.How can you avoid fake reversals? i find myself putting or calling a trade that looks like its going to reverse and then it keeps rallying in its original direction.how can I avoid this?

Hi Tanaka, I recommend not to trade before the reversal happens. The price should go back for at least 10 pips before opening a trade in reverse direction.

I enjoyed the article so much. Wouldd you happen to mentor people?

Dear Mamidza, yes, if I have time, I gladly respond to any questions either in my mail or beneath every article �� Just ask away!

Market Reversals and How to Spot Them

Capturing trending movements in a stock or other type of asset can be lucrative. However, getting caught in a reversal is what most traders who pursue trendings stock fear. A reversal is anytime the trend direction of a stock or other type of asset changes. Being able to spot the potential of a reversal signals to a trader that they should consider exiting their trade when conditions no longer look favorable. Reversal signals can also be used to trigger new trades, since the reversal may cause a new trend to start.

In his book “The Logical Trader,” Mark Fisher discusses techniques for identifying potential market tops and bottoms. While Fisher’s techniques serve the same purpose as the head and shoulders or double top/bottom chart patterns discussed in Thomas Bulkowski’s seminal work “Encyclopedia of Chart Patterns,” Fisher’s methods provide signals sooner, giving investors an early warning of possible changes in the direction of the current trend.

One technique that Fisher discusses is called the “sushi roll.” While it has nothing to do with food, it was conceived over lunch where a number of traders were discussing market setups.

Key Takeaways

  • The “sushi roll” is a technical pattern that can be used as an early warning system to identify potential changes in the market direction of a stock.
  • When the sushi roll pattern emerges in a downtrend, it alerts traders to a potential opportunity to buy a short position, or get out of a short position.
  • When the sushi roll pattern emerges in an uptrend, it alerts traders to a potential opportunity to sell a long position, or buy a short position.
  • A test was conducted using the sushi roll reversal method versus a traditional buy-and-hold strategy in executing trades on the Nasdaq Composite during a 14-year period; sushi roll reversal method returns were 29.31%, while buy-and-hold only returned 10.66%.

Sushi Roll Reversal Pattern

Fisher defines the sushi roll reversal pattern as a period of 10 bars where the first five (inside bars) are confined within a narrow range of highs and lows and the second five (outside bars) engulf the first five with both a higher high and lower low. The pattern is similar to a bearish or bullish engulfing pattern, except that instead of a pattern of two single bars, it is composed of multiple bars.

When the sushi roll pattern appears in a downtrend, it warns of a possible trend reversal, showing a potential opportunity to buy or exit a short position. If the sushi roll pattern occurs during an uptrend, the trader could sell a long position or possibly enter a short position.

While Fisher discusses five- or 10-bar patterns, neither the number or the duration of bars is set in stone. The trick is to identify a pattern consisting of the number of both inside and outside bars that are the best fit, given the chosen stock or commodity, and using a time frame that matches the overall desired time in the trade.

The second trend reversal pattern that Fisher explains is recommended for the longer-term trader and is called the outside reversal week. It is similar to a sushi roll except that it uses daily data starting on a Monday and ending on a Friday. The pattern takes a total of 10 days and occurs when a five-day trading inside week is immediately followed by an outside or engulfing week with a higher high and lower low.

Testing the Sushi Roll Reversal

A test was conducted on the NASDAQ Composite Index to see if the sushi roll pattern could have helped identify turning points over a 14-year period between 1990 and 2004. In the doubling of the period of the outside reversal week to two 10-daily bar sequences, signals were less frequent but proved more reliable. Constructing the chart consisted of using two trading weeks back-to-back, so that the pattern started on a Monday and took an average of four weeks to complete. This pattern was deemed the rolling inside/outside reversal (RIOR).

Every two week section of the pattern (two bars on a weekly chart, which is equivalent to 10 trading days) is outlined by a rectangle. The magenta trendlines show the dominant trend. The pattern often acts as a good confirmation that the trend has changed and will be followed shortly after by a trend line break.

Once the pattern forms, a stop loss can be placed above the pattern for short trades, or below the pattern for long trades.

The test was conducted based on how the rolling inside/outside reversal (RIOR) to enter and exit long positions would have performed, compared to an investor using a buy-and-hold strategy. Even though the NASDAQ composite topped out at 5132 in March 2000 (due to the nearly 80% correction that followed), buying on January 2, 1990 and holding until the end of the test period on January 30, 2004 would still have earned the buy-and-hold investor 1585 points over 3,567 trading days (14.1 years). The investor would have earned an average annual return of 10.66%.

The trader who entered a long position on the open of the day following a RIOR buy signal (day 21 of the pattern) and who sold at the open on the day following a sell signal, would have entered their first trade on January 29, 1991, and exited the last trade on January 30, 2004 (with the termination of the test). This trader would have made a total of 11 trades and been in the market for 1,977 trading days (7.9 years) or 55.4% of the time. However, this trader would have done substantially better, capturing a total of 3,531.94 points or 225% of the buy-and-hold strategy. When time in the market is considered, the RIOR trader’s annual return would have been 29.31%, not including the cost of commissions.

Using Weekly Data

The same test was conducted on the NASDAQ Composite Index using weekly data: using 10 weeks of data instead of the 10 days (or two weeks) used above. This time, the first or inside rectangle was set to 10 weeks, and the second or outside rectangle to eight weeks, because this combination was found to be better at generating sell signals than two five-week rectangles or two 10-week rectangles.

In total, five signals were generated and the profit was 2,923.77 points. The trader would have been in the market for 381 (7.3 years) of the total 713.4 weeks (14.1 years), or 53% of the time. This works out to an annual return of 21.46%. The weekly RIOR system is a good primary trading system but is perhaps most valuable as a tool for providing back up signals to the daily system discussed prior to this example.

Trend Reversal Confirmation

Regardless of whether a 10-minute bar or weekly bars were used, the trend reversal trading system worked well in the tests, at least over the test period, which included both a substantial uptrend and downtrend.

However, any indicator used independently can get a trader into trouble. One pillar of technical analysis is the importance of confirmation. A trading technique is far more reliable when there is a secondary indicator used to confirm signals.

Given the risk in trying to pick a top or bottom of the market, it is essential that at a minimum, the trader uses a trendline break to confirm a signal and always employ a stop loss in case they are wrong. In our tests, the relative strength index (RSI) also gave good confirmation at many of the reversal points in the way of negative divergence.

Reversals are caused by moves to new highs or lows. Therefore, these patterns will continue to play out in the market going forward. An investor can watch for these types of patterns, along with confirmation from other indicators, on current price charts.

The Bottom Line

Timing trades to enter at market bottoms and exit at tops will always involve risk. Techniques such as the sushi roll, outside reversal week, or rolling inside/outside reversal–when used in conjunction with a confirmation indicator–can be very useful trading strategies to help the trader maximize and protect their hard-earned money.

How to Identify Reversals

Properly distinguishing between retracements and reversals can reduce the number of losing trades and even set you up with some winning trades.

Classifying a price movement as a retracement or a reversal is very important. It’s up there with paying taxes. *cough*

Retracements Reversals
Usually occurs after huge price movements. Can occur at anytime.
Short-term, short-lived reversal. Long-term price movement
Fundamentals (i.e., the macroeconomic environment) do NOT change. Fundamentals DO change, which is usually the catalyst for the long-term reversal.
In an uptrend, buying interest is present, making it likely for price to rally. In a downtrend, selling interest is present, making it likely for price to decline. In an uptrend, there is very little buying interest forcing the price to fall lower. In a downtrend, there is very little selling interest forcing the price to rise further.

Identifying Retracements

Method #1: Fibonacci Retracement

A popular way to identify retracements is to use Fibonacci levels.

If price goes beyond these levels, it may signal that a reversal is happening. Notice how we didn’t say will.

As you may have figured out by now, technical analysis isn’t an exact science, which means nothing certain… especially in forex markets.

In this case, price took a breather and rested at the 61.8% Fibonacci retracement level before resuming the uptrend.

After a while, it pulled back again and settled at the 50% retracement level before heading higher.

Method #2: Pivot Points

Another way to see if price is staging a reversal is to use pivot points.

In a DOWNTREND, forex traders will look at the higher resistance points (R1, R2, R3) and wait for it to break.

If broken, a reversal could be in the making! For more information or another refresher, check out the Pivot Points lesson!

Method #3: Trend Lines

The last method is to use trend lines. When a major trend line is broken, a reversal may be in effect.

By using this technical tool in conjunction with candlestick chart patterns discussed earlier, a forex trader may be able to get a high probability of a reversal.

While these methods can identify reversals, they aren’t the only way. At the end of the day, nothing can substitute for practice and experience.

With enough screen time, you can find a method that suits your forex trading personality in identifying retracements and reversals.

Part 11: Technical Analysis – Confirming reversal using indicators

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Ever wondered how to use technical indicators in trading? Well wonder no more, this article introduces 7 popular indicators, and the strategies you can use to profit from their signals.

Technical trading involves reviewing charts and making decisions based on patterns and indicators.

These patterns are particular shapes that candlesticks form on a chart, and can give you information about where the price is likely to go next.

Indicators are additions or overlays on the chart that provide extra information through mathematical calculations on price and volume. They also tell you where the price is likely to go next.

There are 4 major types of indicator:

Trend indicators tell you which direction the market is moving in, if there is a trend at all. They’re sometimes called oscillators, because they tend to move between high and low values like a wave. Trend indicators we’ll discuss include Parabolic SAR, parts of the Ichimoku Kinko Hyo, and Moving Average Convergence Divergence (MACD).

Momentum indicators tell you how strong the trend is and can also tell you if a reversal is going to occur. They can be useful for picking out price tops and bottoms. Momentum indicators include Relative Strength Index (RSI), Stochastic, Average Directional Index (ADX), and Ichimoku Kinko Hyo.

Volume indicators tell you how volume is changing over time, how many units of bitcoin are being bought and sold over time. This is useful because when the price changes, the volume gives an indication of how strong the move is. Bullish moves on high volume are more likely to be maintained than those on low volume.

We won’t cover volume indicators here, but this class includes On-Balance Volume, Chaikin Money Flow, and Klinger Volume Oscillator.

Volatility indicators tell you how much the price is changing in a given period. Volatility is a very important part of the market, and without it there’s no way to make money! The price has to move for you to make a profit, right?

The higher the volatility is, the faster a price is changing. It tells you nothing about direction, just the range of prices.

Low volatility indicates small price moves, high volatility indicates big price moves. High volatility also suggests that there are price inefficiencies in the market, and traders spell “inefficiency”, P-R-O-F-I-T. We’ll cover 1 volatility indicator today, Bollinger Bands.

So why are indicators so important? Well, they give you an idea of where the price might go next in a given market. At the end of the day, this is what we want to know as traders. Where is the price going to go? So we can position ourselves to take advantage of the move and make money!

As a trader, it’s your job to understand where the market might go, and be prepared for any eventuality. You don’t need to know exactly where the market is going to go, but understand the different possibilities, and be positioned for whichever one materializes.

Remember, traders make money in bull AND bear markets. We take advantage of long AND short positions. Don’t get too attached to the direction of the market, as long as the price is moving you can profit. Indicators will help you to do this.

Without further ado, here are the stars of the show.

1) Bollinger Bands

Bollinger bands are a volatility indicator. They consist of a simple moving average, and 2 lines plotted at 2 standard deviations on either side of the central moving average line. The outer lines make up the band.

Simply, when the band is narrow the market is quiet. When the band is wide the market is loud.

You can use Bollinger Bands to trade in both ranging and trending markets.

In a ranging market, look out for the Bollinger Bounce. The price tends to bounce from one side of the band to the other, always returning to the moving average. You can think of this like regression to the mean. The price naturally returns to the average as time passes.

In this situation, the bands act as dynamic support and resistance levels. If the price hits the top of the band, then place a sell order with a stop loss just above the band to protect against a break out. The price should revert back down towards the average, and maybe even to the bottom band, where you could take profits. Check out the screenshot below.

When the market is trending, you can use the Bollinger Squeeze to time your trade entry and catch breakouts early on. When the bands get closer together (i.e. they squeeze), it indicates that a breakout is about to happen. It doesn’t tell you anything about direction so be prepared for the price to go either way.

If the candles breakout below the bottom band, the move will generally continue in a downtrend.

If the candles breakout above the top band, the move will generally continue in an uptrend. Take a look at the screenshot below.

In summary, look out for the Bollinger Bounce in ranging markets, the price will tend to return to the mean. In trending markets, use the Bollinger Squeeze. It doesn’t tell you which way the price is going to go, just that it’s going to go.

2) Ichimoku Kinko Hyo (AKA Ichimoku Cloud)

Ichimoku Kinko Hyo (AKA Ichimoku Cloud) is a collection of lines plotted on the chart. It’s an indicator that measures future price momentum, and determines areas of future support and resistance. At first glance this looks like a very complex indicator, so here’s a breakdown of what the different lines mean:

  • Kijun Sen (blue line): Also called standard line or base line, this is calculated by averaging the highest high and the lowest low for the past 26 periods
  • Tenkan Sen (red line): The turning line. It’s derived by averaging the highest high and the lowest low for the past nine periods
  • Chikou Span (green line): Also called the lagging line. It’s today’s closing price plotted 26 periods behind
  • Senkou Span (red/green band): The first Senkou line is calculated by averaging the Tenkan Sen and the Kijun Sen and plotted 26 periods ahead. The second Senkou line is calculated by averaging the highest high and the lowest low over the past 52 periods, and plotting it 26 periods ahead

So how can you translate these lines into trading profits? I’m glad you asked.

The Senkou span acts as dynamic support and resistance levels. If the price is above the Senkou span, the top line acts as first support, and the bottom line as second support.

If the prices below the Senkou span, the bottom line acts as the first resistance, and the top line as the second resistance. Simple as that!

The Kijun Sen (blue line) can be used to confirm trends. If the price breakouts above the Kijun Sen, it’s likely to rise further. Conversely, if the price drops below this line, then it’s likely it’ll go lower.

The Tenkan Sen (red line) can also be used to confirm trends. If the line is moving up or down, it indicates the market is trending. And if it’s moving sideways, then the market is ranging.

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