technical analysis

Reversal Trading Strategy - A Complete Guide

Daksh Murkute | | |

The trend is your friend until it bends, but the bend can be your friend too if you know how to trade it.

 

What exactly is this bend? It’s reversals and in this blog post, I am going to show you how you can trade reversals.

 

Stick around till the end as I’ll teach you the only strategy you’ll need to trade reversals and earn the big pips.

Contents

What are support and resistance?

RSI indicator

What is divergence?

Types of divergences

Reversal trading strategy

What do you think about this strategy?

 

 

I have tried all sorts of strategies, setups, and indicators, but there are two specific things that have stuck with me that are support and resistance, and divergence.

 

Combine these two and you’ll get the perfect and the only strategy you’ll ever need to trade reversals.

 

 

What are support and resistance?

I’m sure you already know about support and resistance but for this strategy, it’s very important and I’ll just brush up on it.

 

Support is the level on the chart from where the price went up, and resistance is the level from where the price went down.

 

 What are support and resistance?

 

On every price chart, you’ll find various levels of support and resistance and these levels are often paid a lot of attention to by traders.

 

But, support and resistance isn’t just a horizontal line on the price chart but rather is an entire zone.

 

Whenever the price reaches these zones in the future trading sessions, then you can expect something to happen with regards to the price.

 

 

RSI indicator

In order to understand divergence, you first need to know what RSI is.

 

RSI stands for Relative Strength Index and it is a technical indicator that tells us about momentum and price strength or weakness.

 

The RSI is placed at the bottom of the chart and its values oscillate between two extreme levels of 100 and 0.

 

RSI indicator

 

There is a formula for the calculation of the values of the RSI but I won’t get into that in this blog post.

 

Even though the values of the RSI oscillate between 100 and 0, there is a thing of overbought and oversold in it.

 

If the value of the RSI is above 70 then it is overbought and if it is below 30 then it is oversold.

 

RSI indicator

 

When the RSI values show overbought then we can expect the price to fall and when it is oversold we can expect it to go up.

 

 

What is divergence?

Now that you know enough about the RSI indicator I’ll tell you what divergence is.

 

So the RSI indicator normally follows the price movement, this means that if the price is going up then the RSI value goes up too, if the price goes down then the RSI value goes down too.

 

But, there are times when things don’t work this way, and that’s when we have to make the most of it.

 

There will be times when the price is going up but the RSI goes down or when the price is going down then the RSI is going up.

 

What is divergence?

 

This is what divergence is. It’s the mismatch between the price movement and the indicator values.

 

Whenever you spot a divergence on the chart, you should straight away know that something’s wrong and something’s going to happen.

 

 

Types of divergences

Divergences also have some types and these can broadly be classified into two types,

  1. Classic RSI divergence
  2. Hidden RSI divergence

 

Furthermore, these two can each be of two types that are bullish and bearish.

 

So in total, we have four types of divergences,

  1. Classic bullish divergence
  2. Classic bearish divergence
  3. Hidden bullish divergence
  4. Hidden bearish divergence

 

In the classic bullish divergence, you’ll see that the price is making lower lows while the RSI value is making a higher low.

 

Types of divergences

 

And as the name suggests, this is a bullish indication and we can expect the price to go up after such type of divergence is formed.

 

Now, in the classic bearish divergence the opposite happens, the price makes higher high and the RSI value makes lower high.

 

Types of divergences

 

Once you see such a thing happening in the market then you can expect the price to fall.

 

Moving on to the third type, hidden bullish divergence, here the price makes higher lows while the RSI value makes a lower low.

 

Types of divergences

 

This is an indication that the price is going to go up.

 

Finally, the hidden bearish divergence, here the price makes lower high and the RSI value makes higher high.

 

Types of divergences

 

This is another bearish indication.

 

 

 

Reversal trading strategy

I’m sure you might be thinking about how all of this relates to the strategy, I’m going to get to now.

 

In this strategy, as I mentioned earlier, you are going to use two things, support and resistance zones and RSI divergence.

 

Now, RSI divergences can form anywhere on the chart but you don’t have to trade all of them.

 

You only have to trade does divergences that are formed at the support and resistance zones.

 

Why these zones? Because they are value areas as a lot of traders are paying attention to it and if price reacts from this zone then it’s a good indication the price move is strong.

 

So first step in this strategy is to spot a value area or a support and resistance zone.

 

Also Read: What are Reversals?

 

Reversal trading strategy

 

I’ll stress again on the part that support and resistance is a zone and it’s not a line.

 

Once you find a good support and resistance zone you need to wait for the price to reach these zones and divergence should form.

 

Revisit the types of divergences that I talked about above and look for any of the four types of divergences to form.

 

Reversal trading strategy

 

But you know what, there’s catch here. You only have to consider those divergences in which the RSI values were overbought or oversold.

 

So we basically have three conditions here,

  1. Price should be at a value area and it can either be a support zone or a resistance zone.
  2. A divergence should be forming.
  3. The divergence should be formed with RSI values either being overbought or oversold.

 

Once these three conditions have been satisfied, you are now allowed to take the trade accordingly and enjoy the pips.

 

Reversal trading strategy

 

Place your stop loss just above the zone, if it’s a short trade, and below the zone, if it’s a long trade.

 

Targets will be up to you. I’d suggest at least having an RRR of 1:2 but you can decide what works for you best only after backtesting the strategy.

 

 

What do you think about this strategy?

This strategy is literally the only one you’ll need to trade reversals properly and do let me know if you liked it or not.

 

Also, would you like to learn a strategy that can allow you to capitalize on breakouts? Let me know and maybe I could teach you one.

 

Don’t forget to share this blog post with others and let them also take advantage of this amazing strategy.

 

Feel free to reach out to me through the comments section for absolutely anything and I’ll get back to it and the earliest.

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