As you already know, when a trend advances for a long time and then begins to consolidate, one of two things may occur:
- The price may move forward in the same manner (continuation breakout)
- Price reversals could occur in the opposite direction (reversal breakout)
Wouldn’t it be convenient to be able to confirm a breakout? If only fakeouts could be prevented… Hmmm…
Well, a way DOES EXIST!
There are actually a few techniques to determine whether a trend appears to be dying and a reversal breakout is necessary.
Moving Average Convergence/Divergence (MACD)
You ought to have a solid understanding of the MACD indicator by this point. If not, you might wish to review our MACD lecture.
One of the most often utilized indicators among forex traders is the MACD, and with good reason. It is straightforward yet dependable, and it can assist you in determining momentum—or, in this case, lack thereof!
There are several methods to display MACD, but one of the “sexiest” ways is to view it as a histogram.
This histogram actually demonstrates the distinction between the slow and rapid MACD lines.
The stronger the momentum, the larger the histogram becomes.
The weakening of momentum is indicated by the histogram being smaller.
So how can we apply this to determine when a trend is about to reverse? glad you asked!
Recall how divergences, a trading indication that arises when the price and indicators move in different directions, are discussed earlier?
MACD demonstrates momentum for us. It would be logical for momentum to grow as the market develops a trend.
Even though the trend is still present, if MACD starts to decline, you can infer that momentum is waning and that the trend may be coming to an end.
As you can see from the image, MACD shrank as the price increased.
This indicated that momentum was waning even if the price was still trending.
We can infer from this data that a trend reversal is very likely.
Relative Strength Index (RSI)
Another momentum indicator that can be used to verify reversal breakouts is the RSI.
In essence, this indicator reveals the variations between higher and lower closing prices during a certain time frame. We won’t go into great detail, but if you’re interested, check out our tutorial on RSI.
Given that it also generates divergences, RSI can be employed similarly to MACD. These divergences can be used to identify potential trend reversals.
RSI is useful for determining how long a trend has been overbought or oversold, though.
A market may be considered overbought if the RSI is above 70, which is a frequent indicator. On the other hand, if the RSI is below 30, that is a typical sign that a market is oversold.
Trends are moves that continue in the same direction over an extended period of time, thus depending on the trend’s direction, you will frequently see the RSI swing into overbought or oversold zone.
A trend may be reversing if it has produced oversold or overbought readings for a considerable amount of time and starts to move back within the RSI’s range.
The RSI indicated that the market was overbought for a billion days in the previous scenario (ok not that long).
When the RSI fell back below 70, it was clear that the trend was set to change.
Next Lesson: How to Detect Fakeouts