Reversal trading is a strategy focused on identifying when trends are about to change direction. While most traders follow trends, reversal traders position themselves to catch the turn, often entering at prices that trend followers would consider risky. When executed correctly, reversal trades can offer excellent risk-reward ratios because you are entering near the extreme of a move.
What is Reversal Trading?
Reversal trading involves identifying stocks that have moved too far in one direction and are likely to reverse. You are essentially betting that the current trend is exhausted and a new trend in the opposite direction is beginning.
Important distinction: Reversal trading is not the same as catching falling knives. Professional reversal traders wait for confirmation signals before entering, not just because a stock has dropped significantly.
Why Reversals Happen
Understanding why reversals occur helps you identify them:
- Exhaustion: Trends run out of buyers (uptrend) or sellers (downtrend)
- Profit-taking: Traders who rode the trend start cashing out
- Key levels: Price reaches major support, resistance, or round numbers
- Oversold/overbought: Extreme readings on momentum indicators
- News catalyst: New information changes the fundamental story
- Short covering: Shorts scramble to cover, reversing downtrends
- Stop runs: After stops are triggered, price often reverses
Reversal Patterns to Watch
Candlestick Reversal Patterns
These single and multi-candle patterns signal potential reversals:
Bullish Reversal Patterns
- Hammer: Small body at top, long lower wick showing buyers rejected lower prices
- Bullish engulfing: Large green candle completely engulfs prior red candle
- Morning star: Three candles showing transition from selling to buying
- Doji at support: Indecision candle after a downtrend
Bearish Reversal Patterns
- Shooting star: Small body at bottom, long upper wick showing sellers rejected higher prices
- Bearish engulfing: Large red candle completely engulfs prior green candle
- Evening star: Three candles showing transition from buying to selling
- Doji at resistance: Indecision candle after an uptrend
Bullish Reversal Example
Stock ABC has been selling off all morning:
- Price drops from $50 to $45 (10% decline)
- At $45, a hammer candle forms on high volume
- RSI shows oversold at 22
- $45 is a prior support level from last week
- Entry: Buy when price breaks above hammer high at $45.50
- Stop: Below hammer low at $44.50
- Target: $47 (prior support now resistance)
Chart Pattern Reversals
Larger patterns that signal trend changes:
- Double bottom: Two lows at similar levels with a peak between them
- Double top: Two highs at similar levels with a trough between them
- Head and shoulders: Classic reversal pattern with three peaks
- Inverse head and shoulders: Bullish version with three troughs
- Rounding bottom: Gradual transition from downtrend to uptrend
Indicators for Reversal Trading
Overbought and Oversold Indicators
- RSI (Relative Strength Index): Below 30 oversold, above 70 overbought
- Stochastic: Similar overbought/oversold signals
- CCI (Commodity Channel Index): Extreme readings signal potential reversals
Divergence Signals
Divergence occurs when price and indicator move in opposite directions:
- Bullish divergence: Price makes lower low, but RSI makes higher low
- Bearish divergence: Price makes higher high, but RSI makes lower high
- Divergence shows momentum weakening before price reverses
Volume Confirmation
- Volume should spike on the reversal candle
- High volume shows strong participation in the reversal
- Low volume reversals are less reliable
Reversal Entry Strategies
1. Confirmation Entry
Wait for a reversal candle to form and enter on the break:
- Identify the reversal candle (hammer, engulfing, etc.)
- Place buy stop above the reversal candle high
- Stop loss below the reversal candle low
- Safest approach with clear risk levels
2. Level Entry
Enter when price reaches a key support or resistance level:
- Identify major support or resistance level
- Enter with a small position as price tests the level
- Add if reversal confirms
- Stop loss beyond the level
3. Indicator Entry
Enter based on extreme indicator readings:
- RSI drops below 20 or rises above 80
- Wait for the indicator to turn back
- Enter when RSI crosses back above 30 (for longs)
- Combines price action with momentum confirmation
Divergence Entry Example
Stock XYZ is in a downtrend:
- Price makes new low at $30
- RSI makes higher low than previous drop (bullish divergence)
- Bullish engulfing candle forms at $30
- Entry: Buy at $30.50 on candle confirmation
- Stop: $29.50 below the swing low
- Target: $33 at prior resistance
Risk Management for Reversal Trades
Position Sizing
Reversal trades are inherently riskier than trend-following trades:
- Use smaller position sizes than trend trades
- Never risk more than 1% of account on a reversal trade
- Consider starting with half position and adding on confirmation
Stop Loss Rules
- Place stops beyond the reversal candle extreme
- If reversing at support, stop goes below support
- Never move stops further away on losing trades
- Accept that some reversals will fail and continue in original direction
Profit Taking
- Take partial profits at first resistance level
- Trail stops to lock in profits on remaining position
- Do not expect reversals to run as far as trend moves
- Target prior swing levels as realistic profit targets
Common Reversal Trading Mistakes
- Fighting strong trends: Trying to pick tops in parabolic moves or bottoms in crashes
- No confirmation: Entering just because price dropped without waiting for reversal signals
- Too large position: Oversizing because you are confident the reversal will work
- Averaging down: Adding to losing reversal trades
- Ignoring volume: Taking reversals with no volume confirmation
- Wrong timeframe: Looking for reversals on tiny timeframes that have no significance
- No stop loss: Letting small losses turn into disasters
Best Conditions for Reversal Trades
- Extended moves: Stock has moved far from average (far from VWAP, moving averages)
- Key levels: Price at major support, resistance, or psychological levels
- Extreme indicators: RSI below 25 or above 75
- Divergence present: Momentum diverging from price
- Catalyst exhaustion: News-driven move that has run its course
- Volume climax: Extreme volume spike often marks turning points
Analyze Your Reversal Trades
Pro Trader Dashboard helps you track which reversal setups work best for your trading style. Identify your most profitable reversal patterns and improve your execution.
Combining Reversal with Other Strategies
Reversal trading works well with other approaches:
- Range trading: Buy reversals at range support, sell at resistance
- Mean reversion: Fade extreme moves back to average
- Options strategies: Sell premium when expecting reversals
- Multi-timeframe: Trade reversals on lower timeframe in direction of higher timeframe trend
Reversal Trading Checklist
- Is the stock extended from its average price (VWAP, moving averages)?
- Is price at a significant support or resistance level?
- Are momentum indicators showing extreme readings?
- Is there divergence between price and indicators?
- Has a reversal candlestick pattern formed?
- Is there volume confirmation on the reversal?
- Is my stop loss in a logical place?
- Is my position size appropriate for a counter-trend trade?
Summary
Reversal trading offers excellent risk-reward opportunities when executed with proper confirmation and risk management. The key is waiting for multiple signals to align: extended price, key levels, extreme indicators, and reversal candlestick patterns. Never fight strong trends blindly, always use stop losses, and size your positions appropriately for counter-trend trades. Track your reversal trades to learn which setups work best in your trading.
Continue your trading education with our guide on pullback trading or learn about range trading strategies.