The Three Types Of Trend Reversal

It may come as a surprise to you to know there are only three types of trend reversal which can occur in the forex market.

By understanding which of these three reversals is taking place, you are able to draw several conclusions about the kind of movement you will inevitably see when the reversal is over. We are going to look at the three types of reversal today and I’m going to explain the causes behind each reversal in terms of where and when the banks have been placing their trades and also the actions of the retail traders who are present in the market when the trend reverses.

 

The Consolidation Reversal

 

We’ll start things off by looking at the consolidation trend reversal.

The consolidation reversal gets its name from the way the market consolidates before a trend reversal actually takes place.

A fairly recent example of a consolidation reversal took place at the beginning of 2013 on AUD/USD.

image of consolidation on daily chart of aud/usd

AUD/USD had been in a consolidation for roughly 6 months before the downtrend eventually got underway, before the consolidation formed the market had been very volatile with large swings up and down and no easily discernible trend.

In a consolidation reversal bank traders are placing trades on one side of the consolidation. In the above example their placing trades at the upper boundary of the consolidation. The lower boundary is used by them to take profits off their trades, not because they actually want to secure profits but to make the market move back up to the upper boundary.

To get all of their sell trades placed into the market the bank traders must make retail traders buy over and over again, when the market comes to the lower boundary most retail traders are selling because the market is moving down, therefore in order to move the market back up the banks must buy from the traders selling.

The way they do this by taking partial profits, there would be no point in them placing buy trades because they are expecting a downtrend to take place and already have sell positions placed in the market, if they began placing buy trades then at some point they’ll have to close the trade, when they close their buy trades it will create down movement, which means they’ll be pushing the market away from where they want to get their sell trades placed.

Have you noticed how there is virtually no buying until the market has moved a large distance lower ?

This is because most of the selling seen after the market broke the lower boundary of the consolidation is from traders closing losing long positions. When the market approached the lower boundary traders would have believed the market is going to bounce higher as it had done the previous three times, if you look at the daily candle which ended up breaking the lower boundary you’ll see it has a wick at the top which means at some point during the day the market was moving higher.

When the traders saw the market move up they assumed a bounce was taking place and started placing long positions with the expectation the market was going to move back to the upper boundary of the consolidation. When it began falling these traders became trapped in their losing trades, as the market falls lower the traders start to close their losing long trades which creates a significant amount of downside movement.

You can see where retail traders began placing sell trades by looking at the buying which occurred when the market hit the 0.9600 level.

The buying is caused by professional traders taking profits off their own sell positions placed back when the market was consolidating, they need additional retail traders to come into the market and place sell trades in order for them to have enough sell orders available to take profits off their own trades, this process which is taking place behind the scenes shows up in the market as buying.  Ask yourself “Who would be buying after such a large move down”?

Although the buying was small and no big pullback or consolidation took place, it’s still the first signal we have of retail traders beginning to go short in the market and we should be wary that the down-move could be coming to an end sooner rather than later.

Another instance of a consolidation reversal is on EUR/JPY just before the 2008 crash.

image of consolidation on weekly chart of eur/jpy

You can see how there was a consolidation forming way before the actually crash took place which begs the question “Did the banks know the crash was coming”?

Take note of how the highs which make up the upper boundary of the consolidation are found close together, in other words each high never manages to move a large distance beyond the previous high. Consolidations which have the highs in the upper boundary close together and the lows in the lower boundary close together are created by professional trader activity whether it be taking profits – closing trades or placing trades.

Unfortunately there is no obvious method for determining whether a consolidation has formed due to profit taking or because bank traders are causing a trend reversal, the only two things you can really use to get some idea of if a reversal is going to take place is the duration of the consolidation itself.

In my experience I would say a consolidation which takes place for a long time i.e 25 weeks+ is a good indication the previous trend is going to continue.

The reason I say this is due to the bias humans have which makes them believe the longer something has gone on for the more likely it is to continue, this is the same bias which makes traders trade in the direction of the trend. The longer the market has been going down the higher the probability it has of going down in the future, or so they believe.

If the market has been in a consolidation for a long enough time people automatically begin to assume it is going to continue consolidating in the future.

This has the effect of making traders forget about the trend previous to the consolidation.

Before the market enters a consolidation most of the traders in the market will be placing trades in the direction of the trend, when the consolidation begins some of these traders will close their trades while others will still hold on to their positions. As the market continues to consolidate over the coming weeks more and more of the trend traders will close their trades due to the trend not continuing and will revert to trying to capture the movement in the consolidation.

 

The Shock Reversal

 

The second type of trend reversal we’re going to look at is the shock reversal.

The shock reversal occurs when the reversal comes as a shock to the traders participating in the previous trend.

Usually in a shock reversal situation there will not be a previous consolidation present in the market, which means bank traders are unlikely to have been able to place a large number of trades in the direction of the reversal itself.

The banks will either place trades during the beginning stages of a reversal before the reversal becomes obvious to everyone in the market or wait until the market has stopped trending and place trades onto the first pullback or consolidation they see take place.

image of trend reversal on daily chart of eur/usd

When EUR/USD reversed from it upwards drift you can see it dropped for 34 days before pausing and retraceing back against the initial down-move.

This shock reversal had bank traders initially going short at the top of the move down, although there was no previous consolidation which the banks could have used to place short trades the run up to the 1.40000 level was heavily promoted by the financial media, I remember at the time most of the news coming through the forex factory news feed focused on whether or not the market was going to break the 1.40000 level.

All of this hype created a lot of anticipation in traders heads as to whether or not will the market break the level, the day finally came when the ECB news was released, during the release the market shot up with a huge bullish large range candle. If you’ve spent any length of time reading some of the articles on my site you’ll know when the market makes a move with a large range candle masses of retail traders will place trades in the direction of the candle.

What made the situation on EUR/USD different was all the hype behind the market breaking the 1.4000 level.

Traders already had it banged into their heads the market may break the level so when they saw the bullish large range candle form the majority of traders will have placed long trades as they believed the market was about to break the 1.4000 barrier.

The bank traders used the mass of buying to place large sell positions, when all the buy orders from the retail traders had been consumed by the sell orders from the bank traders the market started to move lower, forcing all the traders who went long to close their trades at a loss, which is what caused the majority of the down-movement on seen the first thrust down.

image of reversal on 1 hour chart aud/usd

Here we have another shock reversal only this time its on the 1 hour chart of AUD/USD.

Whilst both shock reversals are taken from different currencies and different time-frames overall the psychology of the traders who are caught up in the shock reversal are the same, the only difference is in the EUR/USD example millions of traders were all buying on the move up to the 1.4000 level, in the example above we have a far smaller set of traders buying before the reversal yet the when the first drop occurs the actions of the traders are the same.

All the traders who were long close their trades and the market falls a significant distance lower before stopping and retracing almost 50% of the swing down.

One thing you need to understand about shock reversal situations is after the market reverse from its prior direction a pause will take place.

When it pauses the market will either consolidate or retrace, if it retraces it will not break past the 50% Fibonacci level.

The reason why it won’t break the 50% level is down to what the reversal itself makes the retail traders believe.

When the market makes a sharp unexpected reversal the traders who had trades open in the direction of the preceding movement close their trades at a loss causing the reversal movement to get bigger depending on how many traders were trading in the direction of the trend before the reversal took place.

If the reversal movement is big enough it will make vast quantities of traders place trades in the direction of the reversal movement, which means there will be no opportunity for bank traders to set up a deep pullback scenario as the market will have reversed too much to make the retail traders believe it’s still possible for the market to continue in the direction of the prior trend.

In order for a deep pullback to take place retail traders must still believe to some extent that the market can continue in the direction of the previous trend, in a shock reversal the reversal movement is so large enough the traders will not think the market has any chance of trending in the same direction therefore they place trades in the direction of the reversal movement.

When the banks begin taking profits off the trades which caused the reversal, it will not be possible for the market to retrace a large portion of the reversal movement as all the retail traders will now be placing trades in the direction of the reversal move.

 

The Deep Pullback Reversal

 

The deep pullback reversal is the final type of trend reversal we are going to take a look at, I’ve talked extensively over the last couple of weeks as to what information can be gained by studying deep pullbacks.

The whole point of the deep pullback reversal is to manipulate retail traders into believing the previous trend is going to continue so the bank traders can place more trades in the direction they want the market to reverse.

image of aud/usd downtrend

At the end of the 2008 crash on AUD/USD we can see a deep pullback reversal took place.

By the time the market had reached this point in the downtrend AUD/USD had been falling for 120 days, the strength of which the market dropped coupled with the duration of the downtrend made traders believe the market was certain to continue falling lower. When the retail traders saw the market pullback it immediately gave them an opportunity to get short into what they believed was a continuation of the downtrend.

When the pullback ended and the market began dropping lower, thousands of retail traders piled into the market with short positions as they were sure what they was getting into was a strong trend.

As the market came to a stop near the lows of the swing up and instead began to rise, all of the retail traders who had gone short started to close their short trades which injected a huge amount of buy orders into the market. The move up you see from the 76.4% fib level is for the most part fueled by the buy orders coming into the market from the short traders closing their losing short positions.

In any deep pullback you see the size of the movement created by the deep pullback reversal is dependent on how many traders were placing trades on the deep pullback itself, in the example above we had a massive amount of traders going short as they believed the downtrend was going to continue, when it failed to do so all these traders were forced to admit they were wrong by closing their trades which pushed the market against the downtrend and essentially created a new uptrend.

Trend Reversals And Time-Frames

 

Now I have shown you the three types of trend reversal and what they mean for the trend I want to bring you onto an important point.

The three trend reversals I have shown you above are exactly the same on all time-frames.

Whenever you see a trending movement whether it be on the 1 minute chart, the 5 minute chart or any other time-frame of you choice the trend will always reverse in one of the three ways described above. They reversals themselves will never look the same, there will always be slight differences in terms of candlestick structure and swing structure but the defining characteristics will be present.

In a deep pullback scenario the defining characteristic will be the way the market moves deep into the swing, in a shock reversal situation the market will fail to close beyond the 50% retracement level and in a consolidation reversal there will be a consolidation which has the swing highs and swing lows of the consolidation itself all close together before the market reverses.

The psychology of the traders in the market is the same regardless of what time-frame they operate on, if a set of traders on the 1 minute chart see the market move lower, then pullback and move lower again, they will place sell trades. The same as if a traders on the daily chart see’s the market drop and make a pullback before dropping again. The only difference between trend reversals on different time-frames is the number of traders the reversal is affecting.

Summary

You’ll never be able to predict when a trend reversal is going to occur with 100% accuracy, but by understanding the structure of the reversal taking place and what it means for the psychology of the retail traders operating in the market you can determine with a good degree of certainty what the banks are trying to achieve with the reversal and the limits as to where the market should go during the time it’s reversing.

 

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3 comments

  1. Alex435

    “In a consolidation reversal bank traders are placing trades on one side of the consolidation. In the above example their placing trades at the upper boundary of the consolidation. ”

    Sir, how did you know that?

  2. Alex435

    I mean, how did you know that banks are placing orders at the upper boundary instead of the lower. Thank you.

    PS sorry for my poor english ))

  3. Mark20

    I think it’s because the candles sit around the top of the consolidation for longer as opposed to the fast movement off of the bottom of it that is characteristic of profit taking but I can’t be sure. That’s just my observation but I was wondering that as well.

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