Candlestick reversal patterns in forex trading are critical indicators that signal a potential change in the direction of a currency pair’s price movement.
Recognising these patterns can help you make an informed decision about when to enter or exit a trade.
Understanding both bearish and bullish reversal chart patterns are the key to getting into a trade early to potentially capture significant price movements.
In this article we’ll look at specific candlestick chart reversal patterns, and discuss the best indicators that warn of an imminent price change in direction.
What are candlestick reversal patterns in forex trading?
We all know the price of a currency pair can only move one of three ways – up, down or sideways.
A price reversal in forex trading occurs when the direction of a pair’s price changes, moving from an uptrend to a downtrend, or vice versa.
These reversal patterns are crucial to recognise and understand if you want to time your trades correctly.
They often signal the end of one trend and the beginning of a new one, offering the opportunity to enter or exit positions strategically.
Why do price reversals happen?
Phases of the market cycle
Market price movement is driven by trader psychology. The natural pattern of price movement involves:
- a breakout
- trending in one direction or another
- profit-taking
- sideways price movement
- a breakout, and then the start of new trend
A trending market will naturally reverse at some point as it reaches exhaustion, running out of buyers or sellers.
However, there are various other causes of a price reversal too. These may include:
Technical resistance/support levels reached
When the price reaches key support or resistance levels, it might struggle to move above or below these key price points, and so a price reversal takes place.
Support and resistance levels are often psychological or historical price points where traders expect a change in direction.
In many ways, reversals are a self-fulfilling prophesy.
Traders expect the price to bounce off a well-established support or resistance level, and so subconsciously set their exit points around these key levels.
As the support or resistance level is reached, and these trade exit orders take players out of the market, this has the effect of making the expected price reversal actually happen.
That’s why I describe them as a ‘self-fulfilling prophesy.’
By anticipating the price will bounce at a certain support or resistance level, and setting trade entries or exits accordingly, the combined actions of millions of traders causes the anticipated result to eventuate.
This then reinforces the importance of those support and resistance levels, and so repeats the cycle.
It’s for this reason that range trading can be a profitable trading strategy, as it relies on the price bouncing off those known support and resistance levels.
Profit-taking
After a significant price move in one direction, traders may start to take their profits, leading to a decrease in the momentum of the current trend.
Once momentum slows down, this may indicate to other traders that the trend is running out of steam, and so they too exit their trades, leading to the end of the trend as sellers dominate price action.
The market is then left in limbo for a while, and so will trend sideways, waiting for the beginning of a new trend to form.
At this point, the new trend could form in either direction, and so traders sit on the sidelines, waiting for clear direction to emerge.
Technical indicators showing overbought/oversold conditions
Many traders use technical indicators on their candlestick price charts.
These may include indicators such as the Supertrend, the MACD, the Relative Strength Index (RSI) or many more.
When these indicators show the pair is heading into overbought or oversold territory, it can lead to a stampede for the door.
This can result in many traders simultaneously exiting a trade, which results in a price reversal.
This example shows the RSI indicating overbought conditions, which results in a sudden reversal in price direction.
Market sentiment shift
A change in the overall mood of the market can also lead to price reversals.
Such a shift can be due to a number of reasons, such as:
- an economic data release
- a news event taking place
- a report or announcement taking the market by surprise
All of these events can lead to a change in sentiment, which can cause a sudden price reversal.
Such sudden changes in sentiment are usually sharp, and correlate directly with the release of economic data or a news event.
Often there are no warning candlesticks that a reversal may take place – the action just suddenly happens.
The example below shows how GBP/USD moved 1,800 pips in one day during the Brexit vote.
It’s for this reason that forex traders should always have stop-loss orders in place for their trades.
We never know when a significant news event may happen, so it’s vital to always have a safety-net in place in case of a sudden price reversal or shift due to an unexpected news event.
What are the top candlestick reversal patterns to look out for?
Reversal signals can come from individual price candlesticks, specific candlestick patterns, and also from chart indicators.
Here are the main candlesticks that may indicate a reversal is about to take place:
Doji candlesticks
Doji candlesticks represent indecision in the market. The word doji comes from the Japanese word for ‘simultaneous.’
They form when the opening and closing price are nearly identical, resulting in a small or non-existent candlestick body.
They are often seen after strong upward or downward trends, and suggest that neither the bulls nor the bears are in control.
During periods of consolidation, rows of long-legged dojis are very common. They indicate market indecision.
Long-legged dojis have little or no body, but a long lower shadow or wick, indicating that price action opened and closed at the same level. However, during the period the price was pushed a lot lower, before retreating upwards back to its opening level.
In an uptrend, a doji candlestick may signal a potential bearish reversal, while in a downtrend, it may indicate a bullish reversal pattern.
Wherever you see a doji candlestick, think ‘indecision.’ They are an indication that neither the bulls nor the bears have control of price action, and so a reversal may be imminent.
Hammer candlesticks
The hammer candlestick forms at the bottom of a downtrend, and has a small body with a long lower shadow but no upper wick, indicating strong buying pressure.
They are very often seen at the bottom of a downtrend, so are a strong bullish reversal pattern indicator.
At the bottom of a downtrend, a green (bullish) hammer is a more powerful reversal signal than a red (bearish) hammer, but both may warn of an impending price reversal.
Sellers tried to push the price lower (as shown by the long lower shadow) but ultimately failed, as buying pressure stepped up.
Eventually the bulls won the battle, and so price reversed from the previous downtrend and climbed up again.
Inverted hammer candlesticks
The reverse of a hammer candlestick is an inverted hammer candlestick, which has a long upper wick and a small body, with no tail or a very small tail.
This is also a strong bullish reversal signal at the bottom of a downtrend.
Whenever you see candlesticks that have a very long head or tail in relation to the size of their body, think about what this implies.
Buyers or sellers have tried to push price action in the direction of the long head or tail, but have ultimately failed, and so the price has returned close to where it started.
This implies there are traders wanting to push the price in the direction of the long wick, but there was not sufficient momentum on this one occasion.
However, that momentum may build, so look for a price reversal in the same direction as the long upper or lower wick.
For example, in the case of a green inverted hammer, look for price to go up, because that is the location of the long upper wick.
Hanging Man candlesticks
The Hanging Man candlestick has a similar appearance to an inverted hammer.
However, it appears at the top of an uptrend, and also suggests strong selling pressure, which often leads to a bearish price reversal.
In the example above, bears tried to push the price down at the top of the uptrend, as shown by the long red lower wick, or tail.
The price eventually recovered to close just a little lower, forming the short red body.
However, the presence of the lurking bears scared off any buyers and so the price reversed and went down.
Once it had fallen for a few hours, as shown by the sequence of red candlesticks, the bulls once again had a go, as shown by the second green hammer.
The bears tried to continue the downtrend, as shown by the long tail, but eventually the bulls won, and the price increased.
Shooting Stars
Shooting stars are another top reversal pattern, showing a long upper wick and a small body, with either no lower wick or a very small tail.
There is usually a gap between the body of the shooting star, and the candlesticks which come before and after it.
Although the colour of the shooting star doesn’t really matter, a red shooting star at the top of an uptrend is a stronger signal than a green one.
It is the gap around a shooting star that is worth noting.
The gap implies that the price opened quite a bit higher than the close of the previous candlestick, implying upward buying pressure.
However, although a few bulls tried to push the price higher, as shown up the long upper wick, they ultimately failed and the price fell.
This is the key to understanding that a price reversal is imminent when you see a shooting star at the top of an uptrend.
Multi-candle forex chart reversal patterns
Double Top
The double top pattern forms after an uptrend and features two distinct peaks at roughly the same price level.
It signifies that the price struggled to break higher.
A break below the neckline, the low point between the two peaks, confirms a bearish reversal.
Double Bottom
The double bottom pattern is the bullish counterpart of the double top.
It forms after a downtrend, and features two distinct lows at roughly the same price level.
A break above the neckline indicates a bullish reversal pattern, signalling the end of the downtrend and the start of a new uptrend.
In my trading career I’ve found double bottoms and double tops to be reliable indicators of a trend reversal.
Previously I have based a trading strategy around the reliability of this candlestick reversal pattern.
Head and Shoulders
The head and shoulders pattern is a reliable reversal pattern consisting of three peaks: a higher peak (the head) in between two lower peaks (the shoulders).
The neckline, drawn across the lows between the peaks, acts as the confirmation line.
When the price breaks below the neckline after forming the right shoulder, it indicates a bearish reversal.
Inverse Head and Shoulders
The inverse head and shoulders pattern is the bullish counterpart of the head and shoulders.
It consists of three troughs: a lower trough (head) between two higher troughs (shoulders).
A break above the neckline suggests a bullish reversal, indicating the end of a downtrend.
I use double bottoms and double tops a great deal in my trading.
I’ve found the head and shoulders patterns to be far less common, and therefore I don’t use them a great deal.
However, it’s worth knowing such patterns exist, and how to recognise them, even if you don’t actively use them in any trading strategy.
Having detailed knowledge about reversal chart patterns is vital for all well-rounded traders.
Chart reversal indicators
There are also many indicators that can be used to determine when a price reversal may take place.
Below are six key indicators or charting tools that can help you spot potential reversals on a forex trading chart, along with explanations of how each one works and what to look for.
The tools that we are going to look at today include:
- Moving Average Convergency Divergence (MACD) indicator
- Relative Strength Index (RSI)
- Parabolic SAR
- Stochastic Oscillator
- Bollinger Bands
- Supertrend indicator
Moving Average Convergence Divergence (MACD) indicator
The MACD is a momentum indicator that shows the relationship between two moving averages of a currency pair’s price.
The MACD line is derived from the difference between two exponential moving averages (EMAs), typically the 12-day and 26-day EMAs.
The signal line, usually a nine-day EMA of the MACD line, helps smooth out price data to better spot trends.
A bullish reversal is suggested when the MACD line crosses above the signal line, indicating that upward momentum is building.
Conversely, a bearish reversal is indicated when the MACD line crosses below the signal line, signalling downward momentum.
Divergences between the MACD and the price – where the price makes a new high or low, but the MACD does not – can also indicate a potential reversal.
It’s also essential to consider the histogram, which measures the distance between the MACD and signal lines.
If the histogram starts shrinking after expanding, it could signal a weakening trend, hinting at a possible reversal.
Relative Strength Index (RSI)
The RSI is a momentum oscillator that measures the speed and change of price movements. It is used to identify overbought or oversold conditions in the market.
It ranges from 0 to 100, with readings above 70 typically indicating overbought conditions, and readings below 30 suggesting oversold conditions.
A price reversal might occur when the RSI crosses these critical thresholds.
For instance, if the RSI moves above 70 and then drops below it, a bearish reversal could be imminent.
Similarly, if the RSI moves below 30 and then rises above it, a bullish reversal may be on the horizon.
You should also watch for divergences between the RSI and price action, where the price is moving in the opposite direction of the RSI, as these can be strong indicators of an upcoming reversal.
Parabolic SAR
The Parabolic SAR is a trend-following indicator that provides potential entry and exit points based on the price’s trend direction.
The indicator plots dots above or below the price, depending on the direction of the trend.
When in an uptrend, dots are placed below the price; in a downtrend, they appear above the price.
A reversal is suggested when the dots switch positions.
For example, if the dots move from below the price to above it, this may signal the end of an uptrend and the start of a downtrend, indicating a bearish reversal.
Conversely, dots moving from above to below the price can signal a bullish reversal.
You can use the Parabolic SAR in conjunction with other indicators like the RSI or MACD to confirm signals, thereby reducing the risk of false reversals.
Stochastic Oscillator
The Stochastic Oscillator (prounounced stuh-kas-tik) is a momentum indicator that compares a particular closing price to a range of prices over a certain period.
This comparison helps predict price turning points.
The oscillator has two lines:
- %K, the main line, show in blue on our example
- %D, the yellow line in our example, a 3-day moving average of %K
Reversals are often indicated when the oscillator crosses above 80 (overbought) or below 20 (oversold).
A bearish reversal may be anticipated when the %K line crosses below the %D line in overbought territory.
Conversely, a bullish reversal might occur when %K crosses above %D in oversold territory.
The Stochastic Oscillator can also show divergences, where the price forms a new high or low, but the oscillator doesn’t follow suit.
This divergence can be a strong sign that a reversal is on the way.
Bollinger Bands
Bollinger Bands consist of a middle band (a simple moving average) and two outer bands that represent standard deviations away from the middle band.
The bands widen during periods of high volatility and contract during periods of low volatility.
A reversal might be signalled when the price touches or moves outside the upper or lower bands and then returns inside the bands.
For example, if the price moves above the upper band and then drops back below it, a bearish reversal could be forming.
Similarly, if the price drops below the lower band and then rises above it, a bullish reversal might be imminent.
Bollinger Bands also provide a clear visual representation of market volatility, making it easier to spot potential reversal points when combined with other indicators like the MACD or Supertrend.
Supertrend indicator
The Supertrend indicator is a trend-following indicator that uses the average true range (ATR) to show the prevailing trend and potential reversal points.
The Supertrend is plotted on your price chart and changes colour based on the direction of the trend.
A trend reversal is suggested when the Supertrend line switches positions relative to the price, either above or below.
If the Supertrend shifts from below the price to above it, this may indicate the end of an uptrend and the beginning of a downtrend (bearish reversal).
Conversely, a switch from above to below the price suggests a bullish reversal.
The Supertrend is particularly useful in trending markets, but should be used with other indicators like the Parabolic SAR or MACD in ranging markets to confirm signals and reduce the likelihood of false reversals.
Final thoughts
Mastering the top candlestick reversal patterns in forex trading is essential for anticipating market direction shifts.
Recognising patterns like the head and shoulders, double tops and bottoms, and other key candlestick formations in forex chart patterns can provide you with critical insights into potential price reversals when you are forex trading.
Indicators like the MACD, RSI, Parabolic SAR, Stochastic Oscillator, Bollinger Bands, and the Supertrend indicator serve as valuable tools to confirm these reversals, helping you identify the most opportune moments to enter or exit trades.
Combining these technical tools with a solid understanding of market sentiment and price action can significantly enhance your trading strategy.
By staying vigilant and continually refining your approach, you can better navigate the complexities of the forex market and improve your overall trading performance.
Remember, no single indicator or candlestick pattern is foolproof, so using a combination of these tools whilst also considering broader market conditions will produce the best results.
Till next time, happy trading!
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Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- John Bollinger – Bollinger Bands https://www.bollingerbands.com/
- Louise Bedford – The Secret of Candlestick Charting https://www.tradinggame.com.au/product/technical-analysis/the-secret-of-candlestick-charting
- J. Welles Wilder Jr – inventor of the ATR indicator in his book New Concepts in Technical Trading Systems https://www.amazon.com.au/New-Concepts-Technical-Trading-Systems/
