Easy FX Trend Reversal Trading

11/20/2013 6:00 am EST

Focus: FOREX

Huzefa Hamid

Senior Analyst, DailyForex.com

Huzefa Hamid explains how traders can use these two indicators in tandem to find good entry points.

A while back, I wrote about the Pin Bar candlestick indicator with a trade example that we captured using that chart pattern. And then I introduced the Engulfing Entry Setup, the second core entry for our trades.

Today, we're going to examine a trade that encompasses both the Pin Bar and Engulfing Setup that produced an accurate entry in a trend reversal.

Trading a trend reversal can be the source of the most profitable trades, but it is often the most difficult area to enter for two reasons:

  • the previous trend can simply continue
  • you may be correct that there is an impending reversal, but if the entry is mistimed you'll get stopped out.

That said, this trade example shows that with the correct criteria, you can enter safely in a reversal. So let's get to it. Here's the AUD/USD Daily chart:

chart
Click to Enlarge

Prior to the Pin Bar marked on the chart, the price had been trending down sharply. The Pin Bar marked the first sign the trend may be ending. However, by itself, for me anyway, it did not produce a strong enough confirmation of a trend reversal, as the Pin Bar did not line up with a previous support or Fib level. The trend could have simply been pulling back a little before continuing down.

Then however, the next two candles produced a bullish Engulfing Setup. To recap, an Engulfing Setup means that one candle's body is engulfed in the opposite direction by the next candle, and both candles have short wicks relative to their bodies (precisely, the body must make up at least two thirds of the entire length of the candle).

Now at this point, with a bullish Pin Bar followed immediately by a bullish Engulfing Setup, I was confident enough to enter at the open of the next candle to get at least a 1:1 risk-reward on the trade. The trade hit the profit-target within the next two candles (+125 pips).

It's worth looking at the chart in relation to a trend line. In this previous DailyForex article, I wrote about entering trades using trend lines. Using the same principles, let's take a look at the same chart with the trend line drawn prior to the Pin Bar:

chart
Click to Enlarge

Notice that the once the trend line is broken, the bullish Engulfing Setup tests the downtrend from the other side now as a support level. This gave further confirmation that the Engulfing Setup provided a well-timed entry.

Some interesting points arise about my choice to exit at only 1:1 risk-reward. The next resistance was several hundred pips away, and 1:2 or even 1:3 risk-reward was easily achievable. The reason I exited at 1:1 is that I find Daily charts are long-term compared to my other trades; therefore to stay in a trade for one or two days is a relatively long time for me.

Hence, this was an emotional decision for me rather than a strategic decision. At the very least, I should have taken off some of my position at the first profit target at 1:1, moved the stop-loss to breakeven and rode the rest of the trade up to the next resistance.

In summary:

  • Trend reversals, although tricky to trade, can be traded safely with the right entry criteria.
  • The Pin Bar and Engulfing Setup can reinforce each other, especially when there's no previous support or resistance to clarify the validity of the trade.
  • You can exit too early on long-term charts because you're not used to staying in a trade for a certain amount of time. Trading should be based on strategic rather than emotional decisions.

Huzefa Hamid is a contributor to DailyForex.com and the co-founder of The Forex Room.

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