(08/13/09) Beginners Guide to Finding Great Forex Trades (Part 4)

As you read in the continuation patterns lesson, road trips are some of our favorite vacations. You jump in the car, head out on the open highway and soak in all of the scenery that you miss when you fly somewhere.

Unfortunately, every road trip has to come to an end at some point, and you have to turn around and drive back home. Sometimes you turn straight around and head back immediately, but sometimes you delay heading home for just a little bit as you cruise around a little longer. But either way, you end up turning around.

Currency pairs turn around and end their road trips too. They run into support or resistance levels and eventually turn around and start moving back in the opposite direction. Sometimes they turn around immediately, and sometimes they test the support or resistance level in front of them a few times before finally giving up and turning around. Regardless, however, they eventually end up turning around.

If the currency pair really is at the end of its road trip and is ready to turn around and head home, a reversal pattern will form while the currency pair consolidates. Reversal patterns tell you that the currency pair is going to turn around and reverse its previous trend after it breaks out of the continuation pattern.

Identifying Reversal Patterns

Reversal patterns, like all price patterns, are made of the following four pieces:

Old trend: the trend that the currency pair is in as it starts to form the price pattern
Consolidation zone: a constrained area defined by set support and resistance levels
Breakout point: the point at which the currency pair breaks out of the consolidation zone
New trend: a reversal of the old trend that the currency pair enters as it comes out of the consolidation zone

Reversal Pattern Attributes

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Reversal patterns form in a few different shapes, but for the most part, they look quite similar. The only real difference you will see is in the shape of the consolidation zone. The consolidation zones of some reversal patterns have a single level of support and single level of resistance, while others have multiple levels of support and multiple levels of resistance. Every other aspect of the price pattern is identical.

Reversals During an Uptrend

The following are the most common reversal patterns you will see during an uptrend:

Double tops: Double tops form during an uptrend as the up-trending currency pair hits the same resistance level twice in the consolidation zone.

Triple tops: Triple tops form during an uptrend as the up-trending currency pair hits the same resistance level three times in the consolidation zone.

Head-and-Shoulders tops: Head-and-shoulders tops form during an uptrend as the up-trending currency pair hits a lower resistance level, then a higher resistance level, and then hits the lower resistance level a second time in the consolidation zone.

To see examples of the price patterns we’ve been discussing and how to use them in your trading, watch the video below.

Reversals During a Downtrend

The following are the most common reversal patterns you will see during a downtrend:

Double bottoms: Double bottoms form during a downtrend as the currency pair hits the same support level twice in the consolidation zone.

Triple bottoms: Triple bottoms form during a downtrend as the currency pair hits the same support level three times in the consolidation zone.

Head-and-Shoulders bottoms: Head-and-shoulders bottoms form during a downtrend as the currency pair hits a higher support level, then a lower support level, and then hits the higher support level a second time in the consolidation zone.

See Reversal Patterns in Practice

Learning to identify price patterns enables you to get a glimpse into the future price movement of the currency pair. Whereas technical indicators, like moving averages and the commodity channel index (CCI), lag the current market price, price patterns project into the future. Once you have identified a breakout point, you can get a pretty good idea of where the price is going to go in the near future and can take advantage of that potential movement.

Now watch the video below and stay tuned for Part 5 tomorrow.