The term reversal patterns is very common. But what does it actually mean? What exactly is the definition, and what does it mean for your trading when this pattern appears? This blog post will address these two questions. After reading this article, you will be able to better understand the psychology behind movements. You will be able to better understand and sort your own thoughts.
What is the Reversal Pattern?
The Reversal Pattern is a trend reversal in the price development of a stock or other asset. The reversal describes how a downtrend becomes an uptrend - and vice versa.
What the Reversal Pattern means for your trading
The Reversal Pattern is one of the most important chart formations
In the image, you can see the chart of the stock $TOPS in a 1-minute chart, which will be used to explain the psychology of a reversal in more detail. At the opening of trading, we saw the first push higher with a high of 8.89. We also see that the volume in this green candle is greater than in the first three candles (starting at 9:30 a.m.). The sixth candle after the opening of trading also tries to reach a new daily high, but doesn't quite make it. The volume of this candle is as large as the candle that made the daily high.
What does this mean? This means that we have numerous buyers who anticipated a new daily high. So, what happens if we don't see this new daily high? Then all of these people have to sell (stop loss). This leads to further declines. The first big red candle is created because many people have speculated very aggressively on a new daily high, but now have to sell.
Next, let's look at the daily low. Who is still selling here? All longs (people who bought previously) are now out with a loss and have sold to close their position. Short sellers shorted in the momentum and are taking profits at the daily low. This means that they are also buying. The price begins to rise again. Thus, the psychology is initially neutral. But not for long! Because now I actually want to short (sell short, bet on a falling price). For this, the VWAP indicator is often used (pink-colored line in the chart). We also see that we get a small retracement. Now the fun starts all over again. Who is wrong? What is obvious? If everyone now positions themselves short, only the shorts can be wrong.
We break above the VWAP, the position in the chart above which many shorts place their stops. These are now also stopped out, which is evident in the high volume. The push continues. So, we have the buyers (formerly short sellers) who are closing their position. But we also have fresh buyers who are speculating on the break of the daily high. This time they are lucky and their plan works. But there are also those who buy the breakout above $9. What happens to these people? They are wrong again and are very likely to be stopped out below $9.
Criteria for the Reversal Pattern
In this example, we see different quality criteria that I look for in such a reversal pattern. I want to see the highest volume of the day at this point. Failure is another form of quality assurance. We see that the price clearly fails above the important $9 mark. Furthermore, the same candle also closes below the previous daily high. This encompasses two factors. A trade would have made sense even if it had closed above it, but this situation is even better because more market participants are wrong.
The overarching thesis is the most important. As always, we use top-down analysis in trading: If the trade doesn't make sense on a large scale, we don't even consider the small scale. This is essential! In this case, it made sense in the daily chart because buyers had the opportunity to get out for the first time. To be able to assess this, an Anchored VWAP tool can be of immense help.
Finally, you should remember one thing: When everyone has bought, who is still buying? At this point, it will fall. Conversely, when everyone has sold, who is still selling? At this point, it will rise!