Reversal Zones

What is a Reversal Zone?

A reversal zone is an area on a price chart where the market shows signs of potentially changing direction. It’s often identified by specific patterns, support or resistance levels, and other technical indicators. Traders use reversal zones to anticipate when a trend might end and a new one may begin.

What Does a Reversal Zone Look Like on a Chart?

1. Key Characteristics:

   • Prices start to stall or consolidate after a noticeable trend has occurred. A reversal can occur from any direction of trend. They also tend to happen more often as chart granularity increases, but usually to a small extent. 

   • Candlestick patterns like Doji, hammer, or engulfing candles often appear. These are fairly common and are pretty easy to spot once you understand what they are. 

     1. Doji - This pattern is formed when a stock's open and close (not low and high) are nearly identical, creating a small or nonexistent body. It represents indecision in the market, as neither buyers nor sellers have gained control over the period. There are a few different variations of the Doji that should be noted:

        1. Long Legged: long wicks above and below the nonexistent body which shows volatility and indecision. 

        2. Dragonfly: a long lower wick and no upper wick. This is suggesting potential bullish reversal, meaning you’re likely to see it at the end of a bearish trend. 

        3. Gravestone: the opposite of a Dragonfly. Long upper wick with no lower wick, suggesting a bearish reversal. 

     2. Hammer - This candle stick will have a small body near the top with a long lower wick that is usually at least twice the width of the body. It indicates that sellers pushed the price lower during the session, but buyers regained control and drove the price back up before the session ended. It usually appears at the bottom of a downtrend and signals a potential bullish reversal. 

        1. The low of the hammer is often used as a stop-loss level if a position is entered shortly after the Hammer happens. 

     3. Engulfing - This pattern consists of two candles and happens when the body of the second candle completely engulfs the entire body of the first candle. Picture this: a small bearish (down/red/black) candle followed by a large bullish (up/green/white) candle with a body that has a low and high that are both lower and higher, respectively, than the first candle. The first candle is getting “engulfed”.

        1. Not uncommon for these patterns to be used as entry signals if it’s appearing at a support or resistance level. 

   • Strong rejection wicks may indicate resistance, support, or general exhaustion of the current trend. Some things to look for are that the wick (either upper or lower) is much longer than the candlesticks real body - similar to the Doji but with a body. Some things to remember:

     1.  The longer the wick, the stronger the rejection. 

     2. The smaller the body is, the more reinforced the rejection is.

2. Common Locations:

   • Support and Resistance Levels: Historical price zones where reversals have occurred. Think about a stock that has repeatedly tested a $50 price level and each time it hits it or gets close, it reverses into a bearish trend. That $50 price level would be considered a resistance level. If the price broke through that level with conviction then it would be considered a support level for the new bullish trend.

   • Trendlines: When price touches and bounces off a trendline. The Key with trendlines effectiveness depends on how well the market respects it. The more times price touches a trendline and respects it, the stronger and more reliable the trendline becomes. Trendlines on higher time frames tend to be more reliable than those on lower time frames (1-Minute or 5-Minute charts). The angle of the trendline is also a factor as more gradual trendlines are more dependable over time. One that is too steep will be hard to follow since it’s indicating a trend that is likely unsustainable and has a higher probability of not being respected.

   • Fibonacci Retracement Levels: Particularly 61.8%, 50%, or 38.2%. If you don’t know about Fibonacci retracement levels, don’t stress. This is a very specific part of technical analysis and I'll get into this in a different post.

   • Supply and Demand Zones: Areas where large buy or sell orders have been executed in the past. 

     1. These are usually due to institutional orders. 

        1. Day traders account for ~80% of all active traders, but institutions account for over 75% of all money being moved in the market each day. On a “per person” basis, institutional traders will move a stock much easier than a retail day trader will. Locating the areas where institutions have buy orders or sell orders placed can give you great insight into areas of potential reversal depending on the order type. This is helpful because often times institutional orders don’t get filled all that quickly, especially the larger ones, meaning that once a price drops down to a general area, the institutional buy orders might start getting filled and it could be for tens of millions of dollars that would be instrumental in supporting the bottom of a reversal and driving the price back up on a bullish trend.

        2. The issue with this is that, to my knowledge, there is no direct way to know where or how much an institution is buying or selling or what their pending orders are. We can, however, infer this information by using some tactics. This list is not exhaustive, there are many other options. I just called a few different ones out to give some idea:

           1. Analyze volume spikes - high volume coupled with bullish candles near support is likely an institution buying (coupled with bearish for selling)

           2. Track order flow data - this reveals where large orders are sitting. You can use level 2 data (order book) to see the depth of the market, including pending buy and sell orders at various price levels. You’d want to look for clusters of large orders as these are often placed by institutions. 

           3. Watch for block trades - these are done off-exchange to avoid disrupting the market. Usually done by institutions. 

           4. News and filings

           5. Open interest

           6. Follow smart money indicators like the Commitment of Traders report.

How to Spot a Reversal Zone

1. Price Action Clues:

   • Slowing momentum in the prevailing trend.Think about a roller coaster approaching the top of the peak. It starts to move slower, levels off, then a drop usually follows. 

   • Price struggles to break through a key level (e.g., forms multiple wicks or small candles). A key level could be a resistance line, a trend line, or any other general area that a stock has had a hard time breaking through. 

   • Divergences between price and an oscillator like RSI or MACD. More on these below.

2. Volume Signals:

   • Increased volume during a reversal candle or at the key level indicates market participants (anyone making a trade) are acting.

   • Volume reductions during the approach to the price level may suggest trend exhaustion.

3. Indicators and Tools:

   • Moving Averages: Look for price interaction with a 200-period or 50-period moving average. This part is up for heavy debate. Most traders will find that certain ranges work better or worse for their strategies so it can be heavily dependent on your style of trading to find the range that works for you.

   • RSI Divergence: RSI stands for Relative Strength Index and is a momentum oscillator that measures the speed and change of price movements, plotted on a scale of 0 to 100. If the current value of the RSI is above 70, that’s considered to be overbought, if it’s below 30, that’s considered to be oversold.

     1. Here is a scenario / example to look for: in an uptrend the price makes a new high but RSI makes a lower high (a bearish divergence), this could indicate a potential reversal and an upcoming downtrend. Vice versa for the opposite.

   • MACD Crossovers: MACD stands for Moving Average Convergence Divergence. It’s a trend-following momentum indicator that shows the relationship between two moving averages. The MACD usually will use the 12-EMA (fast) and the 26-EMA (slow). Here we want to look for crossovers near a reversal zone as this can strengthen the move.

     1. Here’s how to use it: You’re watching the downtrend, waiting patiently for the bottom to time your entry. You see a Doji Dragonfly candle stick, volume is holding, potentially with increasing buy volume, then the next few ticks are green and you finally see a MACD crossover with the 12-EMA crossing above the 26-EMA. If volume is holding or growing, this would be a great entry point to go long. 

How to Trade a Reversal Zone

Step 1: Confirm the Zone

• Use multiple factors like price action, volume, and indicators to confirm the likelihood of a reversal.There are many different ways that you can confirm the area where a reversal might take place. Plan ahead, set your zones on your chart and trust your instruments. What we’ve talked about above isn't an exhaustive list, there will always be more indicators and more combinations of tools to help you figure out where a reversal might take place. Try out different strategies and find the one that works best for you.

Step 2: Wait for a Trigger

• Common triggers include:

  • The candle sticks that I mentioned above, those are all common signs of a reversal.

  • Watch your indicators, those are all data driven and will usually paint a clear picture of what is going on that might provide a different perspective.

  • Price action coming after a consolidated period. Though this may not exactly qualify as a reversal, it is still the start of a new trend (no movement changing to movement). 

  • Bouncing off of support, resistance, or trendlines. This wouldn’t be something worth calling out if it didn’t happen enough times in the past!

Step 3: Define Risk and Reward

• Place stop-loss orders just beyond the reversal zone (e.g., below the low of a hammer candle). This could also be whatever you’re comfortable with stomaching. It’s not uncommon to enter into a position only to have it immediately go against you, before it quickly turns around and you go positive. If you’re just starting out, be overly safe. Stop-losses will save you in the long run. Not having one opens you up to loads of risk that a lot of traders aren’t prepared to properly manage.

• Set a realistic target using the next resistance/support level, a profit range, or a Fibonacci extension. Again, if you don’t know about Fibonacci levels, don’t worry, those can be tricky to learn. Setting your target doesn’t need to be complicated though. The less time you’re in a trade, the easier it is to set your targets as something simple like:

  • Capture a $0.10 move (if you’re trading loads of shares).

  • Capture a 1% move. 

Step 4: Execute the Trade

• Go long or short based on the direction of the anticipated reversal. Always go with wherever the trend is going. 

• Use smaller position sizes if the zone lacks multiple confirmations. Normally I would say don’t take the trade,however, with day trading, things are fast paced and sometimes indicators don’t always catch up in time depending on how much they lag. If you have a couple confirmations that are showing a lot of strength in the move, you can potentially trust that, but I’d take a smaller position size. The more experienced you get and the more you focus on trading a specific ticker, like SPY, the easier it will be for you to interpret the moves and make the right choice even if you don’t have as many confirmations. 

Common Trade Setups in Reversal Zones

1. Support Level Reversal:

   • Look for bullish candlestick patterns at historical support.

   • Enter long when price shows a clear breakout from consolidation.

2. Resistance Level Reversal:

   • Identify bearish patterns like shooting stars or bearish engulfing candles at resistance.

   • Enter short after confirmation (e.g., a strong bearish close).

3. Trendline Reversal:

   • Use trendlines to spot where price repeatedly tests and bounces.

   • Wait for candlestick & volume confirmation before entering any position. 

Extra Tips for Trading Reversal Zones

1. Be Patient:

   • Wait for confirmation. Jumping in too early can lead to false breakouts. Trust the data that you’re using, as long as it’s from a reputable source. If you had to choose between not taking a trade vs taking a losing trade, which would you choose?

2. Combine with Fundamentals:

   • Look for news or events that may support the reversal, such as earnings reports or macroeconomic releases. Interest rate meetings are always big conversations these days as an example. 

3. Beware of False Signals:

   • Not every reversal zone will hold; have a solid risk management plan.

   • Always always always set a stop-loss. Will you get stopped out right before the trend goes your way? Yes, you will. But you’ll also get stopped out right before the trend continues going against you. At the end of the day, it’s not always about how much money you made, but how much you kept.

4. Practice on Historical Data:

   • Backtest strategies using historical charts to understand how reversal zones behave in different market conditions.

   • Spend some time looking at charts. Go to a granular level and scroll back a ways to get to historical data. Then move the chart forwards little by little bit looking at indicators and the candles sticks to see if you can spot tops, bottoms, potential reversals, etc. This might seem elementary, but going candle by candle is exactly how it’s done live. 

5. Understand that you don’t need to make a million dollars on every trade:

   • Keep a reasonable profit goal. It’s much better to make small consistent gains than to make huge bets that could really set you back. To make an example of this, do some simple math. What is the value of your portfolio if you were to make 1% every trading day for a month? 

In Closing

Reversal zones are powerful tools for day traders when used correctly. By combining the things we’ve talked about today as well as adding some additional tools of your own (like building your own tckrAI Analyst), you can set yourself up to really capitalize on these price movements.