Spotting a downtrend early is necessary to take profit from a long position or make an entry in short-selling. Here are some of the easiest techniques for you to try.
A downtrend mostly consists of lower highs and lower lows. This shows that the sellers are dominating the market and as a result, pushing the price downward. It simply tells you to get out of the asset you've purchased, so the profits won't be lost in the falling prices.
For this reason, it would be very much helpful if you can spot the downtrend as soon as it starts by waiting for a bearish reversal and short-sell when the price reaches its peak.
So in this article, we'll learn how to spot downtrend reversal using the following candlestick patterns:
- Bearing Engulfing
- Shooting Star
Let's get to know the easiest ways to spot a downtrend early and take advantage of it!
Spotting Downtrend Reversals
Fairly speaking, spotting a reversal early is not easy, even for expert traders. The reason is that in the early stages of reversals, there's always a chance of correction and the price will move back in the original direction. This is quite crucial because if you get a false signal and quit too early, you might miss a bigger opportunity in the future.
Another issue is the fact that the market is not always trending. Oftentimes, financial markets are in a ranging trend, which means the price tends to move sideways and there's no clear direction whether the price is going to go up or down soon.
Spotting reversals during this time is also important because it can tell you when a major trend might start or it can give you signals for short-term trading opportunities. The latter is particularly useful for active day traders who trade frequently within a single day.
Now one of the easiest techniques that you can use to spot downtrends is by using candlestick patterns. Candlesticks are able to tell various useful insights for traders as well as give out signals for the changes in market sentiment, including the signal for reversals. Here are the two most popular and effective reversal patterns to check out.
The bearish engulfing pattern is one of the best patterns known to provide a clear signal for bearish reversals. You can normally spot this pattern on top of a strong uptrend, so the appearance basically indicates that there's going to be a reversal soon.
The pattern is marked by the first bullish candle being "engulfed" by a larger second bearish candle, indicating a strong shift toward lower prices. The following picture shows what a bearish engulfing pattern looks like.
It's worth noting that the size of this bullish first candle may vary as long as the body of the candle gets completely "engulfed" by the next candle. But even so, Doji candles or other small bullish candles are considered better in this position. These types of candles are able to provide the strongest signal because they reflect the ongoing uncertainty in the current trend.
Furthermore, the pattern has greater reliability if the shadow of the second candle is longer than the shadow of the first candle. Simply put, a much larger bearish candle shows more strength than if it is only slightly bigger than the bullish candle.
Trading with a bearish engulfing pattern is pretty simple.
Once you spot the pattern, it's best to wait for the second candle to close, and then take action on the following candle.
You can either make an exit for a long position or enter the market for a short position.
If you're opening a new sell order, place the stop loss above the upper shadow of the second candle and place a take profit according to your preferred risk/reward ratio.
Alternatively, it's also a great idea to use trading indicators to confirm the reversal, such as Relative Index Strength (RSI).
You might be wondering why we should put the stop loss above the wick of the second candle. The reason is that the bearish engulfing pattern is often used to determine the resistance area as well. This means many traders would expect that the pattern will create a new high that's difficult to break. Once the price breaks the barrier, it could be thought that the pattern is no longer valid.
To get a better understanding of this pattern, let's check out the chart below.
The chart shows that the price starts with a pretty strong uptrend before forming a bearish engulfing pattern. Typically, it's not exactly wise to open a new short trade if the uptrend is very strong.
Even the formation of a bearish engulfing may not be able to stop the buyers from going long. However, we can see that on the chart above, the signals provided by the pattern are quite substantial, so you can immediately open a sell position based on that alone. That being said, it's important to consider the overall picture of the market before taking action.
A shooting star is another popular Japanese candlestick pattern for a bearish reversal. Unlike the previous pattern, this one only consists of a single candlestick. The main characteristic is that the candle has a long upper shadow, small or no lower shadow, and a small body near the bottom.
The candlestick is formed when the price is pushed higher and immediately rejected lower so that it leaves a long wick on the upper side. The long wick must take up at least half the size of the total length of the candle. And since it indicates a downtrend reversal, shooting star patterns must appear after an uptrend.
Basically, shooting star candles indicate a potential price top and reversal to a downtrend. The candle is considered more powerful when it forms after a series of three or more consecutive bullish candles with higher highs.
In that case, a shooting star candle typically opens and rises strongly during the day. As the day goes on, the sellers begin to step in and push the price downward, indicating that the buyers are losing control of the market.
When it comes to the shooting star pattern, always pay attention to the next candle for signal confirmation. Make sure that the next candle's high is below the high of the shooting star candle and then continue to close below the close of the shooting star candle. This indicates that the price will continue to fall and is a great entry point for opening a sell order.
Another thing to keep in mind is the accuracy of the pattern. There are two factors that you need to focus on, namely the time frame and resistance level.
If you're a beginner trader, the daily time frame (D1) is recommended since lower time frames have a high risk of producing many noises that could lead up to false signals.
As for the resistance level, you need to make sure that the pattern shows up when the price is getting closer to the resistance area. It would also be useful to focus on the support level to determine your exit point.
A downtrend occurs when the overall trend is moving downward because the sellers are winning over the buyers. Downtrends are great if you want to short-sell the asset you've purchased or take profit from your long position. However, spotting downtrends reversals can be quite tricky.
Even by using the candlestick patterns explained above, there's no guarantee that the price will absolutely continue to move lower and form a downtrend.
This is why it's highly crucial to confirm the signal with other trading indicators or tools. It would also be useful to manage the trade by placing stop loss and taking profit at strategic places.