Further talk on reversal bars
This lesson will cover the following
- Waiting for a signal
- Following the trend
- What about overlap cases?
As any market has the potential to trend upwards or downwards after any bar, appearing on the price chart, therefore, any bar may be considered as a setup, allowing a trader to enter both into a long and a short position. A setup bar may become a signal-providing bar, only if one enters into a trade on the next bar (which respectively becomes an entry bar). A setup bar, viewed all by itself, does not provide a reason for a trade to be initiated. A setup bar needs to be examined only in relation to bars preceding it. In case this bar is a part of a reversal or a continuation pattern, it may give a reason to enter into a trade.
Lying in wait for a signal
Beginner traders should note that a key moment in price action trading is the expectation that the market has the potential to begin swinging up or swinging down on the next bar. There is a reason why some traders emerge extremely successful. They do not stop to think about reasons why the price may climb or fall on the next bar. Thus, at any moment they expect a signal bar to appear, while prepared to open a position as soon as a suitable setup occurs.
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Following the trend
We have already said in our prior guide that every trader strives to detect early and ride a developing trend. A successful trade is likely to come after a signal bar, which is actually a strong trend bar, confirming the direction of the trade.
Price action traders are usually searching for an imbalance between the bulls and the bears above or below the previous bar. A reversal bar actually reflects such an imbalance. A trader can enter the market after a trend, consisting of only one bar, if he/she expects more trending in his/her direction.
It is worth saying that if a strong uptrend is developing you can go long for whatever reason. You can even go long above the high of a strong bear trend bar, if, of course, you place a wide enough stop-loss. The more resilient this uptrend is, the less important it is for you to look for a strong signal bar, in order to enter in the direction of the trend. However, it becomes more important for you to look for a strong signal bar, which would allow you to enter into a countertrend trade. It is vital to enter the market after the correct side (buyers or sellers) has already taken control of the signal bar at least.
When you intend to enter into a countertrend trade during a strong trend, first, you need to see that a trend line is breached and second, that a strong reversal bar is appearing on the test of the extreme level. Let us provide an example. A downtrend comes to an end, the bulls overpower the bears and prices surge. When the price returns to the area of the already registered low, this means that a test is taking place, with its sole purpose being to determine whether the bulls will enter again at that low or the bears will manage to take control and cause the price to plunge below that low. In case the bears are not successful in their second attempt to breach this low, the market will likely move to the upside for some time. When the market attempts to make one and the same move twice and fails, it will eventually attempt to make the opposite move. Traders are usually not convinced that a reversal is at hand until the market tests the extreme level of the old trend.
In case a reversal bar overlaps one or more of the preceding bars or its wick extends beyond these previous bars by a few pips, it is possible that the reversal bar is a part of a trading range. If that is really the case, a reversal is highly unlikely, because prices move in a trading range (they do not trend). The bar in question should not be taken as a signal bar!
If a signal bar is large and overlaps greatly the preceding two or three bars, this may be a suggestion that the bar in question belongs to a trading range. This is usually the case with bull and bear flags, which may trap anxious traders, positioned in the direction of the trend.
Let us imagine a market, that has been in a consolidation (trading range) during the day. A sudden up move follows to some pips above the exponential moving average. Then, the market demonstrates a flat trend lasting a few bar until a strong bull reversal bar appears on the chart. A bull flag has formed. Some traders would be lured to make a long entry a few pips below the top of the bull flag. However, in many cases this might turn out to be a bull trap, because the market may move in the opposite direction soon after the entry has been made.
If the midpoint of a bull reversal bar is above the low price of the previous bar in a probable reversal up (respectively, the midpoint of a bear reversal bar is below the high price of the previous bar in a probable reversal down), this may imply a significant overlap, thus, a trading range to follow is a greater possibility than a reversal.
If the body of the bar is small, but the bar itself is large, which signifies a doji, this would better not be used as a signal for a reversal trade. A formidable doji represents a trading range of only one bar, so to go long at the top of a trading range in a downtrend or to go short at the bottom of a trading range in an uptrend will certainly not be a successful trade!
In case a bull reversal bar has a large upper wick or a bear reversal bar has a large lower wick, this means that countertrend traders are not convinced they should go into the close of the bar. A trade in the opposite direction of the trend may be entered, only if a trader assumes the body of the bar looks reasonably strong.
If a reversal bar looks considerably smaller compared to the previous several bars, while its body is also small, this implies that the bar may not be used as a signal for a countertrend trade!
There are cases, in which during a strong trend a reversal bar appears, but moments before this bar closes, no reversal follows. Let us provide an example. We are in a strong downtrend and eventually we detect a large bull reversal bar with a long lower wick, its last price is far above its open price and above the closing price of the preceding bar, while its low price extends below the line of a bear channel. However, moments before the bar closes, prices fall and the bar closes on its low. We did not see a bull reversal bar forming where the trend channel line was surpassed. Instead a strong bear trend bar formed and if a trader has gone long early, expecting a strong reversal to the upside, he now finds himself/herself trapped. He/she needs to close the position at a loss, which will boost the move downwards.
A large bull reversal bar with a small body needs to be taken into account in relation to previous price action. The long lower wick signals that sellers have been overpowered by buyers. But, if the bar significantly overlaps the previous bar or few bars, this means that this bar might be a trading range when viewed on smaller time frames. The close at the top of the bar signifies a close at the top of the trading range. As buyers on smaller time frames take their profits, their selling drives the price down. In such a case additional price action is required, so that one can enter in direction against the trend. Going long at the top of a flag in a downtrend or going short at the bottom of a flag in an uptrend will not result in a successful trade!
Beginner traders should also note that any reversal on any time frame may appear to be an ideal reversal on some other time frame. In case one detects a developing reversal, but does not see a reversal bar on his/her chart, it is not recommended to look through a number of other charts for the one, where a perfect reversal is visualized. His/her objective is to determine what actually happens in the market, not looking for an ideal formation. If prices are attempting to reverse, it is better to find a way in the market, not wasting energy and losing focus looking for a perfect reversal bar.