How Reversal Patterns Work

Reversal candlestick psychology is one of the reasons why reversal patterns are such effective predictors of price reversals.

Here’s why:

In the above diagram, the bullish engulfing pattern has formed and the market is now moving up.
The previous sellers (from the bearish candlestick) are now sitting on paper losses, and will be looking to exit their trades at break-even (or so they hope) with ‘buy’ orders, thus forming an area of support.
If prices move back down into the range of the bearish candlestick body, the sellers will quickly close their ‘sell’ trades (with ‘buy’ orders), which pushes the market price up again.

Similarly, after a bearish engulfing pattern has formed and prices continue to move down, the previous sellers (from the bullish candlestick) are sitting on paper losses and will be looking to exit their trades at break-even with ‘sell’ orders, forming an area of resistance.

If prices move back up into the range of the bull candlestick body, the previous buyers will immediately exit their trades (with ‘sell’ orders), pushing the market price down again.

This is a useful concept to consider when looking to enter or exit your trades.

No Man’s Land

The concepts we’ve covered so far involves the crucial periods when the market signals to us where it’s likely to go in the near future.

However, these signals do not often appear. In fact, most of the time the market price will move randomly and will not show a tendency towards any particular direction.This is when the market is in no man’s land, and we do not want to be entering trades during this period.
So how do we know when the market price is in ‘no man’s land’?

For now, we can simply assume ‘no man’s land’ to be in any situation when the price momentum is weakening.

As traders, our job is to be constantly aware of how the market price is moving: is it moving with strong momentum? Or is it mindlessly fluctuating about in no-man’s land?

Our assessment of the situation will determine if we should be looking to enter a trade, or to be staying out of the market.

All right! This wraps up the fundamental concepts of price action. Let’s now put these concepts to the test!


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