Trendlines are probably the most basic technical trading tool and one of the oldest tools used in technical analysis . To this day, trendlines continually form on the charts of financial markets across all the different timeframes providing regular opportunities for traders to jump in and profit on a piece of the action.
The trendline reversal trading strategy rests on the premise that most of the price action in the FX market forms trendlines and is contained by trendlines. As we’ll see in the examples later, as one trendline breaks another one forms and so on. It’s a continuous process actually.
- Advantages of the Trendline Reversal Strategy are: Provides a valid trading opportunity, either short or long, out of almost all setups. Most of the time, it’s only a question of which trendline is broken and which one stays in place (we will call it the healthy trendline).
- Provides opportunities where most of the time the risk-reward ratio offered is great, usually 1:2 or more. This is because we place our stop just behind the healthy trendline and we ride with the move until a support or resistance zone is hit at a later time.
The essential idea of this strategy is: Just follow the trendlines!
The trader should constantly monitor both the support and resistance trendlines and redraw them as the old ones break and new ones form. When an intersection of the projections happens, one of the trendlines must be broken and the other will most likely continue to hold the price. We trade in the direction of the trendline that remained unbroken.
The following chart is a perfect example that highlights the philosophy of this trading strategy. Basically, we are constantly monitoring and drawing trendlines, and judging by the changes in the slope of every new trendline we can determine how likely a reversal is at any particular point in time. In this case on the AUDUSD 4h chart, it was pretty clear that a reversal was imminent and we could have timed the entry to catch a nice profit of the move.
AUDUSD was making higher highs on this chart, however, upon closer inspection, we can see that the slope of the upward, support trendlines underneath was decreasing until it finally turned flat horizontal before the bearish breakout.
More importantly, a very steep resistance trendline formed from the top that finally caused the breakout and is used as the stop loss point for this trade.
AUDUSD 4h chart – A nice U-turn formed by price action and emphasized with the trendlines
Initial stop loss placement of the Trendline Reversal Forex Strategy:
After one of the trendlines is broken, and we enter the trade in the direction of the healthy trendline the protective stop loss is placed behind the healthy trendline.
The next chart is another example of how this strategy works.
After the downward trendline was broken the price didn’t continue up immediately but first retested the broken trendline from the other side. In this case price action didn’t just confirm the breakout of the old trendline but it also confirmed the formation of the new upward trendline – based on which a trade is taken according to this strategy.
USDJPY 4h chart - A great example of intersecting trendlines providing a great place to enter the market
Stop loss management – trailing the stop
It’s only logical that after we enter a trade based on a trendline we should trail the stop behind that trendline. Basically, as long as the trendline holds we want to be in the trade and as soon as it’s broken we want to be out of the trade at once.
USDCAD 4h chart - As soon as the trendline is broken we exit the position
Take Profit of the Trendline Reversal Forex Strategy:
Unlike the entry, we don’t have to wait for a break of the trendline to exit the trade. In fact, in order to capture maximum profits, you need to exit at some technical level before the price takes a turn and reverses.