What is a trend ?
To understand what a trend reversal is, we must first start by defining a trend. Simply put, a trend is a series of lower and higher lows and higher and higher highs as we can see on the chart just below.
Conversely, a downtrend is a sequence of lower and lower lows and lower and lower highs as we can see in the chart below.
What is a trend reversal?
We now know how to determine the existence of a trend and it’s not that complicated, right? Well, for a trend reversal to occur, prices must also follow a few simple rules.
In the case of an uptrend in place :
– Prices fail to register a higher high, which results in a lower high.
– Prices register a lower low.
If we have one of these two characteristics, we still can’t draw a conclusion even if they are good clues for the future, we have to wait for the confirmation of a lower high and a lower low to conclude that the uptrend is reversing.
In the case of a downtrend :
– Prices fail to register a lower low, which results in a higher low.
– The prices register a higher high after the higher low.
As with the uptrend reversal, we cannot rely on only one of the two characteristics.
What are the clues?
As I said above, even if it is necessary to wait for confirmation to declare a trend reversal, there are several clues that we can use to guide us on how to proceed while waiting for the reversal.
The Japanese Candlesticks
Japanese candlesticks are the most classic way to represent stock prices. They can take different forms and will therefore have a different meaning.
The hammer, which is characterised by a long wick and a smaller body can indicate an imminent bullish reversal. This will of course not be enough but it can prevent us from opening a new short position if we are waiting for a bullish reversal to be confirmed.
Fibonacci levels are also very useful tools to help us detect reversals. Indeed, it is not uncommon to see a last low before reversal around the 61.8% Fibonacci reversal.
As with candlesticks, this should be used as a cautionary measure until a reversal is confirmed.
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