Reversal Trading Strategies

1. Head and Shoulders Pattern

The Head and Shoulders pattern is one of the most well-known reversal signals. It appears as three peaks on a chart: the middle one (head) is the highest, flanked by two lower peaks (shoulders).

Entry Point

• For a standard Head and Shoulders (downtrend): Enter when the price breaks below the neckline.

• For an Inverse Head and Shoulders (uptrend): Enter when the price breaks above the neckline.

Stop Loss

• For a standard pattern: Place your stop loss above the right shoulder.

If the price climbs above this level, the expected downtrend Reversal might not materialize, and the pattern could fail in trading. Placing the Stop Loss here helps limit potential losses by exiting the trade if the Reversal does not occur as anticipated.

• For an inverse pattern: Place your stop loss below the right shoulder.

If the price drops below this point, it indicates that the anticipated uptrend Reversal may not unfold, signaling a failure of the pattern. Setting your Stop Loss at this level ensures you exit the trade to avoid larger losses if the market direction continues downward.

Target

To set your Target for a Reversal in trading, measure the height from the head to the neckline and project this distance downward (for standard) or upward (for inverse).

2.  Double Top and Double Bottom Strategy

Double Top and Double Bottom patterns signal trend exhaustion and potential reversals.

A Double Top happens when prices rise to a high point, drop slightly, and then rise to that high point again before falling even more. This chart reversal pattern indicates that the market might start to move downward.

On the other hand, a Double Bottom occurs when prices drop to a low, rise again, and then drop to the same low before climbing more noticeably. This suggests that the market could move upward.

Entry Point

• Double Top: Enter when the price breaks below the low between the two peaks.

• Double Bottom: Enter when price breaks above the high between the two troughs.

Stop Loss

• Double Top: Place above the second peak.

• Double Bottom: Place below the second trough.

Target

• Double Top: Measure the distance from the peaks to the support level and project it downward from the breakout point.

• Double Bottom: Measure the distance from the troughs to the resistance level and project it upward from the breakout point.

3. Fibonacci Retracement Strategy

The Fibonacci Retracement levels are used in this trading strategy to predict where prices might pause or reverse. This method involves using specific percentages - known as Fibonacci strategy ratios.

Traders apply these ratios to a price move to determine potential support or resistance levels. These are points on the chart where prices might stop falling or rising and possibly change direction.

Entry Point

Look for price action near Fibonacci levels -23.6%, 38.2%, 50%, 61.8%, confirmed by candlestick signals.

Stop Loss

Place beyond the next Fibonacci level after your entry. This trading strategy gives your trade enough room to breathe. It provides a clear boundary to cut losses if the Reversal doesn’t go as planned.

Target

Use Fibonacci extension levels (161.8%, 261.8%, 423.6%) or previous support/resistance zones to place your target.

4. RSI Divergence Reversal Strategy

RSI Divergence occurs when price moves in the opposite direction of the Relative Strength Index (RSI), suggesting potential trend reversals

Entry Point

Look for a situation in your strategy where the price of an asset makes a new high but the RSI indicator does not. While the price increases, the momentum behind the price movement decreases. This mismatch is known as divergence and can signal that the price might soon start to fall.

• Bullish Divergence: Price forms a lower low, but RSI forms a higher low, suggesting a potential upward reversal.

• Bearish Divergence: Price forms a higher high, but RSI forms a lower high, suggesting a potential downward reversal.

Stop Loss

Place a Stop Loss beyond the recent high/low.

For example, in a bearish Reversal Trading strategy signaled by RSI Divergence - where the price makes a higher high while the RSI makes a lower high - you would set your Stop Loss above the recent high reached by the price. If the expected downward trend does not materialize and the price rises, your position will be closed at a predefined point, thus limiting your losses.

Target

Use past support/resistance levels or a predefined risk-reward ratio to place your target.

In a bullish Reversal scenario, where you enter a buy trade because the price makes a lower low but the RSI indicates a higher low, your Target should be set where you anticipate the price will rise to before potentially reversing again or stabilizing. A practical approach is to identify previous resistance levels on the chart — areas where the price has historically struggled to break through and may pause or pull back.

5. Moving Average Crossover Strategy

The Moving Average Crossover strategy, essential in both Reversal and Momentum Trading, tracks price trends using two lines: a short-term and a long-term moving average. When these two lines cross, it can signal a shift in the market.

If the short-term line crosses below the long-term line, it's a hint that prices might start falling, indicating a bearish (downward) Reversal. On the other hand, if the short-term line crosses above the long-term line, prices may rise, signaling a bullish (upward) Reversal.

Entry Point

Enter the trade when the crossover occurs:

• Bullish crossover: When the short-term Moving Average crosses above the long-term average, this suggests it's a good time to enter a buy trade.

• Bearish crossover: If the short-term average crosses below the long-term average, it indicates an opportune moment to enter a sell trade.

Stop Loss

• If you enter a buy trade  (when the short-term Moving Average crosses above the long-term average), you should place your Stop Loss below the most recent swing low. This protects you from losing too much if the price unexpectedly drops.

• For a sell trade (when the short-term Moving Average crosses below the long-term average), set your Stop Loss above the most recent swing high. If the price suddenly rises, your potential losses are minimized.

Target

Use past resistance/support zones or a 2:1 risk-reward ratio to define profit targets.

For instance, if your Stop Loss is set $10 below your entry price, you might set your Target $20 above your entry price.