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?

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.

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:

• Long Legged: Long wicks above and below the nonexistent body, which shows volatility and indecision.
• Dragonfly: A long lower wick and no upper wick, suggesting potential bullish reversal, meaning you’re likely to see it at the end of a bearish trend.
• Gravestone: The opposite of a Dragonfly. Long upper wick with no lower wick, suggesting a bearish reversal.

Hammer

This candlestick 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.

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

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.”

It’s 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:

• The wick (either upper or lower) is much longer than the candlestick’s real body - similar to the Doji but with a body.
• The longer the wick, the stronger the rejection.
• The smaller the body is, the more reinforced the rejection is.

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 trendline 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. These are usually due to institutional orders. 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.

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:

• Analyze volume spikes - high volume coupled with bullish candles near support is likely an institution buying (coupled with bearish for selling).
• 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. Look for clusters of large orders as these are often placed by institutions.
• Watch for block trades - these are done off-exchange to avoid disrupting the market. Usually done by institutions.
• News and filings
• Open interest
• Follow smart money indicators like the Commitment of Traders report.

How to Spot a Reversal Zone

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).
• Divergences between price and an oscillator like RSI or MACD.

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.

Indicators and Tools:

• Moving Averages: Look for price interaction with a 200-period or 50-period moving average. The effectiveness ranges depend on your strategy and style of trading.
• RSI Divergence: RSI (Relative Strength Index) measures the speed and change of price movements on a scale of 0 to 100. Above 70 is considered overbought, below 30 oversold. In an uptrend, if the price makes a new high but RSI makes a lower high (a bearish divergence), it could indicate a potential reversal. Vice versa for the opposite.
• MACD Crossovers: MACD (Moving Average Convergence Divergence) uses the 12-EMA (fast) and the 26-EMA (slow). Look for crossovers near a reversal zone as this can strengthen the move. For example, in a downtrend, you’re watching for the bottom. You see a Doji Dragonfly, volume is holding or increasing, then a MACD crossover with the 12-EMA crossing above the 26-EMA occurs. If volume is holding or growing, this could 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 to confirm where a reversal might take place. Plan ahead, set your zones on your chart and trust your instruments.

Step 2: Wait for a Trigger

Common triggers include:

• Candlestick patterns mentioned above (Doji, Hammer, Engulfing).
• Watching your indicators for data-driven signals.
• Price action coming after a consolidated period. Though this may not exactly be a reversal, it can still start a new trend.
• Bouncing off of support, resistance, or trendlines.

Step 3: Define Risk and Reward

• Place stop-loss orders just beyond the reversal zone (e.g., below the low of a hammer candle).
• Set a realistic target using the next resistance/support level, a profit range, or a Fibonacci extension. Keep it simple if you’re just starting out, such as capturing a small price move or a small percentage gain.

Step 4: Execute the Trade

Go long or short based on the direction of the anticipated reversal. Always go with the trend. If the zone lacks multiple confirmations, consider using smaller position sizes. With more experience and focus on a specific ticker, it gets easier to interpret the moves even with fewer confirmations.

Common Trade Setups in Reversal Zones

Support Level Reversal:

• Look for bullish candlestick patterns at historical support.
• Enter long when price shows a clear breakout from consolidation.

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).

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

• Be Patient: Wait for confirmation. Jumping in too early can lead to false breakouts.
• Combine with Fundamentals: Look for news or events that may support the reversal, such as earnings reports or macroeconomic releases.
• Beware of False Signals: Not every reversal zone will hold; have a solid risk management plan. Always set a stop-loss.
• Practice on Historical Data: Backtest strategies using historical charts to understand how reversal zones behave in different market conditions.
• Understand that you don’t need to make a million dollars on every trade: Small, consistent gains over time can grow your account steadily. Consider the math of making just 1% every trading day for a month.

In Closing

Reversal zones are powerful tools for day traders when used correctly. By combining the concepts we’ve discussed—patterns, indicators, volume analysis, and more—you can set yourself up to capitalize on these price movements. With practice, patience, and the right strategy, reversal zones can become a key part of your trading toolkit.

Happy Trading
Brandon