The term “trend reversal” is widely used but poorly understood and usually requires some clarification. Some think that this means that a downtrend is going to “flip” and become an uptrend after news or a technical signal. The reality is rather that that an event will often temporarily stop the current trend and create a zone of indecision which has three possible outcomes:
- the current trend will resume
- the trend will change
- uncertainty will continue and result in a trading range
This applies to current events, for Western technical analysis (double tops, double hollow shoulder-head-shoulder, etc.) and for the Japanese candlestick analysis.
Despite this, the study of reversal figures is essential in trading because often it is after these figures that positions will be taken. There are areas of uncertainty, in no apparent order, which are difficult to classify and therefore not easily studied and used but also figures that recur regularly and whose probabilities of success are interesting enough to give rise to positions being taken. The best known are the hammer, the hanged man and the various stars.
An important point to grasp is that trading with reversal figures and trading against the trend reversal is not the same thing. Indeed, a primary trend is broken in waves that are called secondary trends, which are themselves decomposed into waves called tertiary trends. At each level, primary, secondary and tertiary figure reversals take place. The most interesting use of figures of reversals will be used to enter a trend of a higher degree.
Take for example the following evolution of rates: a bullish primary trend composed of advanced secondary bullish and bearish side of corrections (See graph).
We see that the figures of reversals are not inconsistent with the trading in the direction of the trend. The blue arrows were very good entry points that arose after a figure of reversal. In comparison, the orange arrows were far less interesting because they were returned against the primary trend.
To follow the different levels of a trend, primary, secondary and tertiary, it is interesting to study the evolution of prices across different time, this is what is called “time-scaling”. The same asset is then studied in the long term (days, H4) to identify the primary trends in the medium term (H1, M30) for secondary trends and short-term for tertiary trends (M10, M5). These time units are given for information only and should be adapted according to the market and style of trading but the principle is valid for the long-term investment to very short term scalping.