The reversal strategy

What is a reversal setup?

A reversal trading strategy is a way of trading where you try to profit from a reversal in price direction. Instead of going with the trend (like in a breakout strategy), you try to buy at the lowest point of a decline or sell at the highest point of a rise. The idea is that the price has gone "too far" at some point and will reverse back.

For beginner traders, this may sound like the perfect moment to enter: you buy when everyone is selling, or sell when everyone is buying. But be careful: The market can continue moving in one direction for a long time. If you enter too early, you can lose a lot of money. It's therefore important to understand when you can expect a real reversal and when it's just a pullback.

Why reversals work (and when they don't)

Reversals work because markets don't move linearly. After a strong rise or fall, the market often becomes "exhausted." There simply aren't enough buyers or sellers left to continue the ongoing price movement. This can potentially cause a reversal, but not every decline or rise automatically ends in a reversal. Sometimes it's just a pullback or consolidation before the trend continues.

Essential rules for a valid reversal trade

The danger for beginners is that they want to beat the markets. You're inclined to buy at the lowest possible price and sell at the highest possible price. So as soon as you see a hesitation in a trend, you jump in immediately expecting the price to reverse. However, trends can last a long time, and if you're too eager, you'll take loss after loss on your trades. There are therefore a number of conditions that must be met for it to be a valid reversal setup.

Strong trend or movement beforehand

A reversal only has a chance of success if there has first been a clear, strong movement. This can be a long uptrend that becomes exhausted, or a sharp decline that has gone too far. Without a strong movement beforehand, there's no "exhaustion" and thus no reason for a reversal. Look for at least 3-5 candles in the same direction with little to no counter-movement.

Clear support or resistance zone

A reversal works best at important price levels where the market has previously reacted. These are support zones (where the price previously found support during a decline) or resistance zones (where the price previously found resistance during a rise). In these zones, many orders are typically waiting, so you can expect a reaction. Without a clear support or resistance zone, a reversal is much riskier.

Signs of exhaustion

A trend usually only reverses when something clearly changes in the order flow. Watch for:

• Ending volume: A sudden increase in volume when the price hits a support/resistance zone. These are stop losses and/or targets being filled, showing that big players are becoming active.
• Trend break: The ongoing trend is broken. You can see this by drawing a line along the trend and waiting for the price to break that line in the opposite direction.
• Decreasing momentum: The price makes one last push in the trend direction, but indicators like RSI or MACD don't follow. This difference (divergence) warns that the trend is on its last legs.

Reversal candlestick pattern

A reliable reversal setup has a clear reversal candlestick. The most common are:

• Hammer: A candle with a long lower wick and small body, indicating that sellers were rejected
• Engulfing pattern: A large candle that completely "eats" the previous candle, indicating a strong reversal
• Doji: A candle where open and close are almost equal, indicating uncertainty and possible reversal

How do you enter a reversal trade?

Found a good reversal setup? Then it's time to determine how you're going to take this trade. There are different entry strategies possible for this setup, ranging from aggressive to defensive.

Entry after a higher low or retest

Trends usually don't move in a straight line, but with so-called pullbacks. For this example, we'll assume a downtrend: The price makes a long downward movement and consistently makes lower highs and lower lows. When the price reaches the support level, we see a reversal candle and the price suddenly makes a higher high. For our entry, we now wait for the price to also form a higher low, and then we enter. This gives us a lot of confirmation that the trend is indeed going to reverse. This is the safest and most defensive way to enter, but it can also be that the price suddenly reverses and then you miss the boat.

Entry after confirmation

This entry strategy is slightly more aggressive: We enter as soon as the second candle after the reversal candle confirms the reversal. If the second candle clearly moves against the direction of the old trend, we enter and assume this movement will continue.

Entry directly at the trend break

This is the most aggressive way to enter. We enter directly as soon as the price breaks the trendline, without waiting for further confirmation. In potential, you can make more return here, but the risk that the trade fails is also higher.

Stop loss and target: proper placement

Correctly placing your stop loss and target is essential for successful reversal trading. Here's how to do it:

Stop loss placement

Your stop loss should always be placed at a level where your reversal setup becomes invalid. If the price hits this level, it means the reversal didn't work. A stop loss can also be placed more defensively or aggressively. Exactly where depends on your entry strategy.

Most common stop losses:

• Entry after retest: Stop loss below/above the retest (aggressive) or above/below the high or low of day (defensive)
• Entry in confirmation candle: Stop loss directly below or above the candle where you entered (aggressive)
• Entry at trend break: Stop loss a bit above/below the high or low of day (defensive)

Important rule: NEVER move your stop loss further away "to give it room." If your reversal setup is valid, the price shouldn't go below/above your stop loss. If it does, the setup simply didn't work.

TP/Target placement

Your take profit should be realistic and based on important price levels. A common mistake beginners make is setting targets too high and wanting to trade through levels. Keep it realistic:

• An important level. The chance is high that the price will reverse here (again), so this is the most logical target.
• VWAP is a level; the price almost always reacts to it. So don't try to trade through it and take your profit when the price comes near the VWAP. You can optionally take a partial and let part run.
• The previous (intraday) swing high or low. Here too you can choose a partial, but make sure you take part of your profit here and move your stop loss at least to break-even.

Risk-reward ratio: Make sure your target is at least 2x as far as your stop loss (risk-reward ratio of 1:2 or better). If you risk 50 euros, you should be able to win at least 100 euros. If your target is too close, the trade isn't worth it.

Common mistakes in reversal trading

The reversal is a fairly easy strategy to learn, but as always, there are also a lot of (emotional) mistakes lurking with this strategy:

Mistake 1: Entering too early

You see a decline to a level and think "this must be the lowest point" and enter immediately. You don't wait for any confirmation and the trend wasn't broken yet. Result: the price continues to fall and you take a loss.

Solution: Stick to your entry strategy.

Mistake 2: No clear support/resistance

You see a reversal pattern but there's no clear support or resistance zone. You enter based solely on the pattern. Result: the reversal doesn't follow through and the price falls away again.

Solution: Only trade reversals at clear support or resistance zones on the daily, 4h or 1h chart.

Mistake 3: Too small risk-reward ratio

You see an attractive setup, but the VWAP is already at 1.5R. You decide to try it anyway. Result: Your target isn't reached and you still take a loss.

Solution: Only trade if you can achieve at least a 1:2 risk-reward ratio to the first point of resistance.

Mistake 4: No exit strategy

You enter without a clear target. You just hope the price keeps moving in your favor. Result: You could have taken a nice profit, but you let it evaporate again and earn nothing.

Solution: Determine your exit strategy in advance. You can choose a fixed target, or you can trail with your stop loss. The latter pays off especially when a new, strong trend forms with your trade.

Mistake 5: Trading reversals in a (too) strong trend

You try to trade a reversal while the market is in a strong, clear trend. Result: It turned out to be just a short pullback and you take a loss. Also preferably trade reversals with the daily trend. The trend is your friend.

Solution: Only trade reversals when the trend shows signs of exhaustion, or in range-bound markets.

Reversal strategy in practice: an example

Suppose you're looking at a chart of a stock that has fallen sharply from 100 euros to 95 euros over the past 2 hours. This is a clear, strong movement. The price now arrives at an important support zone at 95 euros where the price previously found support.

You see that:

1. ✅ There has been a strong decline
2. ✅ The price reaches an important support zone
3. ✅ Momentum is low
4. ✅ A buyers candle forms with increased volume
5. ⏳ You wait for confirmation...

The next candle goes up and closes above the high of the hammer. This is your confirmation!

Your action:

• Entry: You wait for the price to make a higher low and enter as soon as the top of the buyers candle is hit again
• Stop loss: You place your stop loss below the low of the hammer candle (also the LOD: low of day), for example at 94.80 euros
• Target: Your first target is the VWAP at 97.60 euros

Your risk: 95.50 - 94.80 = 0.70 euros per share Your potential profit: 97.60 - 95.50 = 2.10 euros per share Risk-reward ratio: 1:3 (very good!)

If you buy 100 shares, you risk 70 euros to potentially win 210 euros. This is a good risk-reward ratio.

Why TradeLogger is essential for reversal traders

Trading reversals requires discipline and consistency. Even the best setups don't always work, and there may be certain assets where reversals work better than others. TradeLogger helps you get and maintain an overview. TradeLogger can also help you fine-tune your strategy.

Track your reversal performance

Log every reversal trade in TradeLogger and see immediately:

• What is your win rate with reversal trades?
• What is your average risk-reward ratio?
• At what times do your reversals work best?
• On which stocks do reversals work best?

Discover patterns

You might discover that your reversal trades work much better on average on Mondays than on Fridays. Or that long reversals perform much better than short reversals. These insights are gold, but you only see them with detailed statistics.

Improve your entry, stop loss and risk-reward

By analyzing your entries and exits, you can see per ticker what the ideal stop loss is on average and adjust your trades accordingly, so you can achieve the optimal risk-reward ratio and get the most out of each trade.

Mentor feedback

Your mentor can analyze your reversal trades via TradeLogger and help you see where you can improve. Most mistakes you make are emotional. Your mentor looks through your emotions and helps you stay on the right path.

Conclusion: Trading reversals for beginners

The reversal trading strategy can be very profitable, but requires discipline and strict rules. As a beginner, it's important to:

1. Only trade the best setups - Only trade A-setups
2. Always use a stop loss - Protect your account
3. Set realistic targets - Take your profit in time
4. Log your trades - Learn from your trades, profitable or not

Trading is not a "quick win"; losses are part of it. It requires patience and discipline to trade profitably in the long term. With the right approach and good statistics, you stay in control of your emotions. Sign up for the TradeLogger waitlist and receive an exclusive discount when you become a member!