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Reversal patterns and technical indicators are two great tools for finding profitable trading opportunities. Combined, they unlock their full potential. This article explains how you can use technical indicators to make the most of your reversal pattern trading with binary options.
- What Are Reversal Patterns?
- Combining Reversal Patterns And Technical Indicators
- How To Trade Reversal Patterns
With this information, you will be able to use technical indicators to support your reversal pattern trading with binary options.
What Are Reversal Patterns?
As the name indicates, reversal patterns are significant price formations that indicate an impending market reversal. The right technical indicators can aid you in trading reversal patterns, unlocking many more trading opportunities for each reversal pattern and helping you to better trade the more well-known opportunities.
There are three main reversal patterns you have to know:
1. The Head And Shoulders Formation
The market is in a trend and reverses. The head and shoulder can both represent an ending uptrend and a beginning downtrend or an ending downtrend and a beginning uptrend. In the picture, you see the top reversal with an ending uptrend. For the bottom reversal, just flip the picture on its head.
2. The Triple Top And The Triple Bottom
The triple top or bottom is a head and shoulders formation with two shoulders that are closer to the extreme. In the picture, you see a triple bottom that indicates and ending downtrend and a beginning uptrend. The triple top is the same thing flipped on the head.
3. The Double Top And The Double Bottom
The double bottom and the double top look very similar to the triple bottom and the triple top. The main difference is that the market forms only two bottoms/tops, and reverses only once between those bottoms.
The beginning of the double top/bottom is the same as with the triple formations. The market creates an extreme and reverses briefly. After that, the patterns are slightly different.
- In a double top/bottom, the market takes longer to form the second bottom. The movement there is erratic and often shows a significantly lower volume. You can see this difference in the picture, where the market seems to stutter its way to the second bottom.
- In a triple top/bottom, the movement to the second extreme is straighter. While its volume is already lower than during the preceding trend, it is higher than in a double formation.
Often, the movement to the second extreme helps you distinguish between the double and the triple formations. We will soon analyse how technical indicators can help you with this important task.
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The double formation completes when the market breaks through the price level of the previous reversal. At this point, a new trend will likely start in the direction of the preceding trend.
Combining Reversal Patterns With Technical Indicators
As you can see with the double formations and the triple formations, reversal patterns are often difficult to distinguish by pattern analysis alone. Only when they are complete, it is easy to see which reversal pattern you are dealing with. Technical indicators can help you to earlier recognize reversal patterns and more accurately define their boundaries
Put yourself in the shoes of a reversal pattern trader. When you think that the market will reverse, there are still many questions to answer. Questions such as:
- Which reversal will the market form?
- Will the market reverse after two highs/lows or will it create three high/lows?
- Will the market form a large reversal pattern or will the pattern be smaller and quicker?
Answering these questions is essential to winning a trade.
- When you think that the market is forming a double bottom, but it is really forming a triple bottom, you might invest too early.
- When you think that the market is forming a triple bottom, but it is really forming a double bottom, you might invest too late.
- When you think that the market is forming a triple top, but it is really forming a head and shoulders top, you will make all sorts of wrong predictions.
Accurately assessing the current market environment is essential to making the right predictions. Technical indicators are the ideal tool for this job. They can do three things for you:
- Technical indicators can help you understand when reversal patterns will form. Leading technical indicators help you understand when a trend is running out of momentum. In these market environments, a reversal will happen soon, which is why you know that you have to search for a reversal pattern. When you see the first signs of a reversal pattern, you know what is going on and can make the right investment decisions. Without technical indicators, you would be late to the party and miss out on great trading opportunities while maybe making bad decisions.
- Technical indicators can help you to find more trading opportunities in a reversal pattern. Understanding reversal patterns will help you recognize the general pattern. But this rough outline is insufficient for making an actual trade. When you know that the market is going through a reversal pattern, technical indicators help you understand how long each movement in this pattern will last. Therefore, you can determine the reach of each swing and trade all kinds of binary options based on this indication.
- Technical indicators can help you understand which reversal pattern you are dealing with. When you understand how far a swing will reach and when it will turn around, you can more easily distinguish the different forms of reversal patterns. When the market is nearing its second high during a bottom reversal, technical indicators can predict whether it will turn around soon and form a triple pattern or continue to rise and form a double bottom. You know what to expect and you can make better trades.
Combined, these three advantages provide you with a much better understanding of reversal patterns. By adding technical indicators, you can significantly improve your accuracy, your timing, and the number of trading opportunities that you find.
These advantages are so significant that every trader should consider adding at least one technical indicator to their trading of reversal patterns. Let’s take a look at how you can do that and which technical indicators can help you in which ways.
How To Trade Reversal Patterns
At this point, it is time to get concrete. We will now outline a few strategies for how to combine reversal patterns and technical indicators. The important point of these strategies is to show you the possibilities and the tools you can use. You do not have to copy these strategies exactly as we present them. Feel free to adapt them to your personal preference or include parts of them in your current strategy.
With that being said, let’s get started.
Strategy 1: Combining Reversal Patterns With The Money Flow Index (MFI)
The first technical indicator that we want to recommend combining with reversal patterns is the Money Flow Index (MFI).
The MFI is simple to understand. It multiplies the price movement of each period with its volume and then compares the sum of periods with rising prices to the sum of periods with falling periods. It presents the result as a percentage value between 0 and 100.
- A value of 0 indicates that all the money has been flowing out of the asset.
- A value of 100 indicates that all the money has been flowing into the asset.
- A value of 66 indicates that two-thirds of the money has been flowing into the asset, and one-third out of it.
You can interpret the MFI in two ways:
- Extreme areas. The MFI has two extreme areas: values over are considered overbought, values under 30 are considered oversold. In both cases, the MFI predicts that the market will soon turn around.
- Failure swings. In an intact trend, the MFI mirrors the market’s movements. As an uptrend climbs higher and higher, the MFI should climb, too. As a downtrend falls lower and lower, the MFI should fall, too. A failure swing happens when the market creates a new extreme without the MFI creating a new extreme, too. This sign indicates that the current trend is running out of momentum and that a reversal will happen soon.
Both of the MFI’s indications are ideal for trading reversal patterns. Here is what you do:
- Wait for the MFI to indicate a reversal. Depending on your preference, you can use extreme areas or failure swings. We recommend waiting for the MFI to enter an extreme area and then start scanning the market for a reversal pattern. When you find a failure swing, there is a good chance that the reversal pattern has already begun.
- Find the reversal pattern. Once the MFI has indicated that the market will reverse soon, it is time to start searching for the reversal pattern. Use pattern analysis and focus on price action. As soon as you have identified the beginning reversal pattern, continue with the next step.
- Identify the reversal pattern. Additionally, use the MFI to identify weakening movements. Switch to a shorter chart period and try to understand when the movements in the longer chart period will end. This way, you can understand whether the pattern will end after two extremes or three swings. If the second retracement begins to weaken as it reaches the price level of the first reversal, you know that the market will likely turn around and create a pattern with three extremes. If the second reversal shows no signs of weakening, you are likely dealing with a double bottom or a double top.
- Trade the pattern itself. Once you have identified the reversal pattern, you can use the MFI to predict impending reversals and more accurately pinpoint the boundaries of the pattern. You know the rough estimate for how far each swing will move. Use the MFI to monitor the strength of the swings as you trade them. If a swing is still strong, predict that the swing will continue. If a swing is beginning to weaken, wait until it indicates a clear reversal, and then invest in the opposite direction. Knowing the strength of each single swing helps you trade binary options types with a higher payout, for example one touch options and ladder options.
- Trade the prediction of the pattern. Once the pattern is complete, you can invest in the new trend that just started. You can use the MFI to confirm this trend. When the reversal pattern completes, the MFI should show no indication of a weakening trend. If the MFI still has enough room to rise and has not yet created a failure swing, predict that the new trend will continue. The exact details of the MFI can help you understand the strength of the current trend and whether you can trade it with a binary options type with high payouts or should play it safe and use high/low options.
In short, you can use the MFI to confirm and evaluate every part of the reversal pattern. You start by finding the market environments in which reversal patterns develop. You continue by using the MFI to time your investments, and you finish by using the MFI to confirm the reversal pattern’s main prediction.
Strategy 2: Combining Reversal Patterns With Moving Averages
The second technical indicator that can help you make the most of reversal patterns is the moving average.
Moving averages calculate the average price of the last periods and draw it into your price chart. For example, when you use a 20-period moving average, the moving average calculates the average price of the last 20 periods and draws it into your chart.
After that, the moving average goes back one period and repeats the process from the perspective of this period. This way, the moving average works its way through your price chart, always calculating the average price for the last 20 periods from the vantage point of each period.
The result of this process is a line. This line can tell you a lot about the market:
- Directionof the moving average line. If the moving average is pointing upwards, the market must be rising. If the moving average is pointing downwards, the market must be falling. When the moving average changes direction, it indicates a change in market sentiment.
- Linein relation to the current market price. If the market is above the moving average, it must have gained upwards momentum in the recent past. If the market is below the moving average, it must have lost momentum. When the market breaks through the moving average, it indicates a changing market environment.
- The moving average as a resistance/support line. The market is always reluctant to break through a moving average. When the market is above the moving average, the moving average works as a support; when the market is below the moving average, the moving average works as a resistance.
These indications are especially strong with significant moving averages. Most traders use moving averages based on 5, 10, 20, 50, 100, or 200 periods, which is why these values work best for a moving average strategy.
Additionally, longer moving averages are more significant than shorter ones. The market will be very reluctant to break through a moving average based on 200 periods, but it will break through a 5-period moving average more willingly.
Similar to moving averages, many other price formations create resistance and support level. You can combine them in a similar way with moving averages.
Strategy 3: Combining Reversal Patterns With Bollinger Bands
Bollinger Bands are a technical indicator that is very similar to moving averages.
The basis of Bollinger bands is a moving average with 20 periods. This moving average creates the middle line of the Bollinger. It is surrounded by an upper and a lower line that are the results of adding and subtracting twice the value of the standard deviation.
Bollinger bands create three lines that surround the market. The upper and the lower line create boundaries which the market is highly unlikely to leave, the middle line works as an additional resistance or support line, depending on whether the market is trading above or below the line.
When you expect that the market is forming a reversal pattern, Bollinger bands can give you a good idea of the rough outline of the pattern.
For example, that the market was in an uptrend that you expect to end. Here’s what you do:
- Use Bollinger bands to identify market environments in which reversal patterns are likely to form. Switch to a time frame that is longer than the time frame that you want to trade. For example, if you want to trade a chart period of 5 minutes, it would make sense to switch to a 1-hour chart. Wait until the market nears the upper range of the Bollinger bands or approaches the middle Bollinger band from below. In both cases, the market is likely to reverse, which, in turn, is likely to create a reversal pattern on a shorter chart period. Once you have found the situation, switch to the shorter chart period.
- Wait until the market trades at the upper range of the Bollinger bands on the shorter period. For an uptrend to have enough room to create a reversal pattern, it has to trade at the upper range of the Bollinger bands. Wait until the market gets there. On the way, you might be able to trade a few binary options that predict this movement, including some that make use of the Bollinger Band’s clear price target to trade an option type with a higher payout such as one touch options.
- Use the Bollinger bands clear price targets to make additional trades. When you know that the market will reverse, you need to predict how far each swing in the reversal pattern can reach. Bollinger bands provide you with clear indications for this task. The market can either reverse to the middle Bollinger band or the lower Bollinger band. The middle Bollinger band is the safer bet, but the lower band can also make sense as a price target if the trend created large reversals before. Use these targets to trade additional binary options.
The key to successfully executing this strategy is choosing the right chart period for your expiry. Bollinger bands change as the moving average and the standard deviation change, which is why you should trade them with an expiry that is close to the period of your chart.
For example, in a 5-minute chart, it would be a bad idea to trade Bollinger bands with an expiry of 2 hours. Until then, the market will have created so many new periods that the Bollinger bands will have changed completely. The predictions from two hours ago are now meaningless.
In this example, it would be better to use an expiry of 15 minutes.
Technical indicators can greatly benefit your trading of reversal patterns. They help you identify market environments in which reversal patterns are likely to form, identify the right reversal pattern, and find additional investment opportunities during the reversal pattern. Combined, these advantages are the reason why every binary options trader should consider adding at least one technical indicator to their reversal pattern strategy.
Three-Bar Reversal Pattern For Day Trading
By Galen Woods in Trading Setups on December 4, 2020
According to Alton Hill, three-bar reversals are too common in intraday time-frames. To select the best three-bar reversal patterns for day trading, he wants the third bar in the pattern to close above the highs of the first two bars.
The diagram below demonstrates the difference between the usual three-bar reversal pattern and Alton Hill’s day trading version.
- Bar 1 closes down
- Low of Bar 2 is below the low of Bar 1 (and Bar 3)
- Bar 3 closes above the high of both Bar 1 and Bar 2
- Buy at the close of Bar 3
- Bar 1 closes up
- High of Bar 2 is above the high of Bar 1 (and Bar 3)
- Bar 3 closes below the low of both Bar 1 and Bar 2
- Sell at the close of Bar 3
This a 5-minute chart of ES futures. It shows the regular session.
I included part of the previous section to show the uptrend that ended yesterday. After our entry, the prices drifted up for the rest of the session.
- The previous session ended with a strong bull trend.
- The three-bar reversal pattern was also the right shoulder of a bullish head and shoulders formation. (You might have noticed that its head was a regular three-bar reversal pattern. In this case, it gave a better entry than our enhanced pattern.)
- The last bar of the pattern closed above the highs of the two previous bars. That was our signal to buy.
This is a 5-minute chart of E-mini Dow contract. Despite a solid signal bar, the pattern failed immediately after entry.
- Although prices fell for seven consecutive bars, the increasing buying pressure is evident as the bars show long bottom tails (shadows).
- Tails developed at the top of the bars during the pullback upwards. Tails on both top and bottom of the bars are giving us mixed signals, implying that prices might be congesting soon.
- If we ignored the above warning signs and shorted the three-bar reversal pattern, we would have entered a losing trade.
Review – Three-Bar Reversal Pattern For Day Trading
This modified three-bar reversal pattern is impressive. A simple rule has turned this typical pattern into a great setup.
Recognize that this added rule is asking for confirmation of the pattern in advance.
Applying the technique of candle blending, if Bar 3 in a standard three-bar reversal pattern has excellent follow-through in Bar 4, blending Bar 3 and Bar 4 would have resulted in this enhanced three-bar reversal pattern.
You can easily combine this pattern with other indicators or price patterns to find high probability trade setups. The winning example is an excellent combination of a head and shoulders formation and a three bar reversal pattern.
However, due to this additional criterion, the signal bar (Bar 3) tends to have a wide range. As our stop-losses are usually placed on the opposite end of the signal bar, the trade risk might be higher. We should either cut down our trade size or tighten the stop if possible. If you are unable to manage the risk, then skip the trade setup.
One last point to note is that if the middle bar of the pattern is an outside bar, be very careful. Outside bars often precede wild and unpredictable price action.
Need an indicator to help you find the Three-Bar Reversal? Click here.
If you want to read more about three-bar patterns, check these out:
9 Tools That Trend Traders Can Use to Find Reversals
What is your trading strategy for finding the most reliable trend reversals?
As a trend trader, you want to position yourself along with the market trend. A trend reversal is both your entry and your exit.
This is why you must answer this question to the best of your ability. Focusing on finding the best reversals will put you on the path to trading success.
Conversely, each false reversal can cause you to miss potential trading setups. It will also have you scrambling to get back into the flow.
For a trend trader, the power of a multi-pronged approach is very real. With a set of varied tools, you can find reliable trend reversals with confirmation.
This brings us back to one important question: what are the best tools for a trend trader?
Like most traders, you probably have a general idea of how to find a reversal. For instance, you might rely on a moving average.
But, you don’t want to stop there. There are two other things that you need to do:
- Learn about different types of trading tools: price action, technical indicators, and volume tools.
- Appreciate the power of including a variety of tools in your trend analysis.
With that in mind, let’s review nine tools that you can combine to find the best trend reversals as a trend trader.
Price Action Tools
Price action is essential. It is a solid cornerstone of a technical trading strategy.
If price is reversing, nobody can argue with that.
#1: Swing Pivots
For examining price action, you need tools that are practical, simple, and useful. This is exactly what you get with swing pivots.
Open any chart and you will see that price does not move in a straight line. It moves in waves. The start and end points of these waves are swing pivots.
I’ll be the first to tell you that there are many ways to define a swing. At the same time, you should focus on one definition so that you don’t get bogged down with too many choices.
Once you’ve marked swing pivots on a chart, higher highs mean a bullish trend. Lower lows mean a bearish trend.
In this example, I’m using the swing definition taught in my price action trading course.
As you can see above, interpreting swings for reversals is not always clear-cut. But with experience, you can use price swings to find areas of potential reversals.
#2: Trend Lines
Trend lines are essential to a trend trader’s search for reversals. A trend line defines and tracks a trend.
The basic signal of a trend reversal is when price breaks a trend line.
However, false breaks are common. Hence, the key is the magnitude of the trend line break.
You can draw trend lines by connecting swing pivots. Again, there are many ways of drawing a trend line. But remember that your choice is less important than staying consistent.
Many traders learn by drawing trend lines ex-post on historical charts. It gives the impression that perfect trend lines are easy to find.
Don’t get into that trap. Instead, develop an objective method of drawing trend lines. Once that is done, you can draw them confidently in real-time.
The trend line in the example below is drawn using the method taught in my price action trading course.
Combining swing pivots with trend lines is a great trend trading method. The 1-2-3 reversal is a basic strategy that relies on swing pivots to define a trend reversal.
You can learn more about the 1-2-3 reversal in Trader Vic’s book.
#3: Price Channels
A price channel is formed by extending a parallel line from a trend line.
Most trends go through a channel phase. During that phase, price action bounces between the trend line and the parallel line. (The parallel line is also known as the channel line).
To find reversals with a trading channel, look for overshoots of the channel line.
Note that this approach anticipates a reversal. It is unlike the trend line strategy above which waits for a trend reversal to take place.
If you are an aggressive trend trader, this price action tool is for you.
A balanced approach is to start with watching for channel overshoots as a warning. Then, look out for a trend line break as confirmation.
While price action is useful, indicators can also help trend traders in finding reversals.
Technical indicators are also suitable for tracking a large set of instruments. You can easily set up clear criteria to scan for potential reversals.
#4: Moving Average
A trend trader can also find reversals with an intermediate to long-term moving average.
My preferred method of using a moving average is by observing its direction.
The strength of moving averages is that you can use a few of them to track trends of varying degrees.
However, apply too many moving averages and you’ll turn this strength into a drawback.
If you are just starting out, consider the 50-period moving average. For tracking shorter trends, you might want to use the 20-period moving average.
#5: Donchian Channel
This is the indicator used by the famous Turtles.
The original strategy’s profitability might have been eroded, but the Donchian Channel maintains its status as a powerful trend tracking tool.
In fact, the Donchian Channel is grounded with price action. It’s not your typical indicator with hard-to-grasp formula.
The Donchian Channel has two lines. They are the highest price and the lowest price attained within the lookback period.
This means that it is simply defining a price range using historical price action.
Let’s take a look at the Donchian Channel in action.
Refer to this free PDF for a detailed explanation of the Turtle trading approach.
#6: Moving Average Convergence Divergence (MACD)
As a trend strengthens, two moving averages of different periods will diverge. As a trend weakens, two moving averages will converge.
This is what Gerald Appel observed and used as the basis for the MACD indicator.
For trend traders, an impressive use of the MACD is for finding price divergences. A price divergence is a powerful reversal signal. It occurs when price and an oscillator disagree.
Technically, you can define a price divergence with two points. However, using three points like in the example above improves the quality of the setup.
Volume are important confirmation tools.
However, as they do not relate to price action directly, they tend to give early signals that might be less reliable.
Nonetheless, when used correctly, they give the trend trader a chance to enter the market before everyone else.
#7: On Balance Volume (OBV)
OBV is a cumulative indicator. It means that its value does not depend on a lookback period. It increases and decreases according to the polarity of each price bar.
The key implication is that you should ignore its values, and focus on its direction.
If both price and OBV are rising, the bullish trend is solid. Once the OBV starts to lose steam, a trend trader might sense danger. A reversal might be impending.
I like to observe the OBV through a long-term moving average of its values. A moving average helps to highlight the trend of the OBV, which is as important as the trend of the market.
In the example below, the background colour shows the slope of the OBV moving average. (green means up and red means down)
To learn more about trading with OBV, take a look at this article.
#8: Volume Oscillator
The Volume Oscillator is a handy tool but you must be careful. As it is based on volume, you must interpret it differently from price oscillators like MACD and RSI.
Positive values do not mean that bullish prices are supported. They mean that the trend, in either direction, is healthy. Negative values mean that the trend is weak.
With this knowledge, trend traders can also use divergences to find potential reversals.
Using the Volume Oscillator well is more challenging than applying price oscillators. Practise more and you will be well-rewarded with a volume perspective to price action.
#9: Volume Extremes
Extreme volume is a sign that the trend might have run its course.
In a rising trend, sudden extreme high volume might be the result of climatic buying. Climatic buying implies that all the buyers have bought. When there are no buyers left, the market can only go one way – down.
The same logic applies in a falling market. Climatic volume might have taken out all the sellers. Then, when there’s no more sellers, the market can only rise.
You can spot extreme high volume bars in retrospect easily. However, in real time, you might hesitate in deciding how high is high.
To solve this problem, you need a more objective method to determine if volume is high. One way is to use Bollinger Bands applied on volume data – orange line in the chart below.
Conclusion – Tools for Trend Traders
As a trend trader, you appreciate the importance of reliable reversal signals. But that’s only half the battle.
If you’re going to look for reversals, you should use an arsenal that includes both price and volume.
Also, don’t throw indicators out of the window. Instead, learn to use them prudently with price action as your beacon.
As you’ve learnt, some tools anticipate a reversal while other confirm a reversal. While no tool is flawless, you can use them to your advantage.
For instance, you can put on a small position based on the anticipation of a reversal. Then, increase to your full position once the reversal is confirmed.
Spotting reversals is one of the toughest but most rewarding trading approach. This is why a trend trader needs the best tools available.
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