A Complete Guide to Reversal Candlestick Patterns

Taking advantage of trending movements is the overall goal of every trader.

As a trader, you want to position yourself on the winning side and not get caught in a reversal that will hurt your portfolio and capital. Trending movements are usually initiated with market reversals. The sooner you get on the new trend, the higher the chance you will be profitable and, the better the R:R (risk-reward) ratio will look. 

In this article, we will look at the definition of reversal candlestick patterns, how they work, and what the market is telling us. We will also share a simple trading strategy to demonstrate how you should take advantage of market reversals.  

Reversal patterns are the opposite of continuation candlestick patterns. While the latter signal that the prevailing trend is likely to continue after a temporary pause is finished and the breakout is confirmed, reversal patterns are pointing towards an impending change in the trend direction. Also, reversal patterns need more time to form than the continuation formations as it is easier for the market to continue in the same direction than change its course. 

 

For instance, the sellers were successful in pushing the market lower up to a point where they started feeling exhausted, which provided the buyers with an opportunity to initiate a change in the trend direction. As such, they provide traders with an opportunity to initiate a new trade as the reversal will start a new trending movement.

For the reversal to take place, the prerequisite is the existence of a previous trend, meaning we can’t classify a start of a new trend as a reversal if the market trades sideways prior to the reversal. You see in a photo below that the market changes the trend direction through the double top reversal pattern.

 

 

 

Although reversals start with a breakout, usually of a strong resistance/support, there are signs prior to that point that signal an impending change in the trend direction. While the trend is characterized by a series of the lower highs and lower lows (downtrend), or the higher highs and higher lows (uptrend), we may see signs of weaknesses in the dying stages.

For example, as the head and shoulders pattern forms, the series of the higher highs is broken with the third peak, which comes at a lower price than the previous one. Alternatively, in the case of a double bottom, the sellers fail to push through the support by creating the equal low and not the lower low.

By definition, trading reversal patterns should be more risky than trading continuation patterns, as it is safer to bet on the winning side. However, reversal patterns are considered to be more powerful since the trends tend to be the strongest in their initial phases. 

This is because initially one side of the market is more dominant, and therefore more successful in pushing the price into their desired direction. After some time, the balance becomes more even as the other side starts growing in the game. Finally, the change in the trend direction is taking place as the other side has now become more dominant. 

 

Therefore, the market is telling us that the overall trend is nearing the end, and the price action is likely to change its course soon. Once the signals align and the likelihood of the market changing its course is high, reversal patterns offer a great R:R ratio. 

The greatest limitation of reversal patterns is that you are still betting on the losing side so far. As an illustration, the buyers are in control in an uptrend. By hoping for a reversal, you are more inclined to put your faith in the sellers, which have been on the wrong side of the market so far. Thus, there is always a possibility of a market continuing in the same direction, despite signals that change is around the corner. 

There are different forms in which the reversal can take place. We make a general distinction between the bullish reversal patterns and bearish reversal patterns. Here, we take a look at some of the most popular reversal candlestick patterns from both categories.

Double Bottom 

The double bottom pattern is a bullish reversal pattern that occurs at the bottom of a downtrend and signals that the sellers, who were in control of the price action so far, are losing momentum. The pattern resembles the letter W due to the two-touched low and a change in the trend direction from a downtrend to an uptrend. 

 

 

Triple bottom

As the name itself says, the triple bottom consists of the three lows made at roughly the same price. It’s a bullish reversal pattern that can be detected at the end of a downtrend. The pattern suggests an impending change in the trend direction after the sellers failed to break the support in three consecutive attempts. 

 

 

Inverse head and shoulders

The bullish version of the traditional head and shoulders pattern is called the inverse head and shoulders formation. It’s a bullish reversal pattern that can be seen at the end of a downtrend. The sellers have run out of gas as they were unable to continue the series of the lower lows, with the third low (the right shoulder) being at a higher level than the previous peak.

Bullish (V) Reversal

Bulllish V-shaped reversals take place after a strong downtrend. They are also called “spike” reversals, or the V-bottom, as the price action tends to spike lower, before the counter-spike to the upside occurs. This reversal pattern is considered to be an unpredictable formation as the market sometimes abruptly changes its course which is difficult to predict and  trade.