Generally, chart patterns show how market participants react toward an asset. For example, if investors or major market players believe that a particular level will not only hold but act to protect the level, there’s a high possibility that a price reversal will occur at that level.
A trader can find trend reversal patterns in forex chart formations, which can help in forecasting the high probability reversal zones. The patterns come in different forms ranging from large structural chart patterns and single candle patterns to a group of candles taking a specific shape.
Experienced traders use the reversal potential of the chart patterns to have an early edge, which allows them to enter into new emerging market directions.
What are the types of reversal chart patterns that exist?
Two major trend reversal patterns exist: the bullish and bearish reversal patterns. The bullish reversal pattern helps traders to forecast that the current bearish move will reverse into a bullish direction; a bearish reversal pattern does the opposite, predicting that the current bullish move will shift into a bearish trend.
Here are some useful reversal patterns that traders should know.
The hammer/shooting star candlestick patterns
As the name suggests, this chart pattern resembles a hammer. It’s a single candle that has a reversal function. It usually has a very long lower shadow, a tiny body, and a non-existent or small upper shadow. Traders rely on the reversal signal from the hammer pattern only if the candle has appeared during a bearish trend.
The hammer pattern itself could be bearish or bullish; that doesn’t affect its function. The shooting star candle, on the other hand, shows up after a bullish trend. Its long shadow is at the upper end of the pattern. The pattern signals the reversal of an existing bullish trend.
Image above showing hammer pattern
Image showing the shooting star pattern
The engulfing candlestick pattern
The engulfing pattern contains two candlesticks. The first candle gets engulfed by the next candle, which means that the body of the second candlestick traps the body of the first candle. If a bullish engulfing occurs at the end of a bearish trend, it means that the trend may reverse upside.
In this case, the first candle will be bearish, while the second or engulfing candle should be bullish and engulf the first candle properly. For a bearish engulfing pattern, the exact opposite occurs.
The image below shows the engulfing pattern.
Doji candlestick pattern
The Doji candlestick pattern is a single candle pattern that is easy to recognise. It usually appears on the charts when the closing and opening price during a period are the same. The structure looks like a cross because it doesn't have a body. The Doji can appear under two conditions: when there’s no volatility in the market or after a prolonged price move.
The pattern signifies exhaustion or indecision in the market. The pattern has a strong reversal potential when it forms after a prolonged price move.
Image showing the Doji candle:
Double top and double bottom pattern
The double top pattern has two tops on the price chart. The pattern forms two peaks on the price chart that are located on the same level. Sometimes, the first top is a bit higher. The pattern looks exactly like the letter M; the opposite of this pattern is the double bottom.
The shape of the double bottom is the reverse of the double top. Therefore, the double bottom looks like the letter W. The two bottoms are on the same resistance level. Occasionally, the first bottom is a bit lower.
The confirmation of the two patterns comes when price breaks the middle of the two tops or bottoms; this is the trigger line.
Double top pattern shown in the image above
The image above shows the double bottom pattern
Head and shoulders pattern
This pattern appears on the charts when there is a bullish trend. In the process, it creates a peak, which is the first shoulder. When a correction occurs, the price action tends to create a higher top, which is the head. Then, another correction results in a third top that is lower than the head; this is the second shoulder.
Traders confirm this pattern when the price breaks the line that passes through the two bottoms on either side of the head. The moment price breaks the line (neckline), traders get a reversal trading signal, which permits them to initiate a trade to the short side.
The reverse version of this pattern is called the inverted head and shoulders pattern. Typically, the pattern occurs after a bearish trend, and traders should trade it in the bullish direction.
The bottom line
Traders must understand that every chart pattern has components that assist in estimating potential price swings. However, to get the best results from trend reversal patterns, traders have to wait for the patterns to be confirmed before using the system.