One way to trade a reversal trading strategy is to look for confluences of reversal signals and indications. Confluences are points on the price chart where there are two or more indications that the price may be moving in a certain direction. This could either be based on candlestick patterns, price patterns, or signals coming from technical indicators. Confluences tend to have a higher likelihood of price moving in a certain direction. Applying confluences on a reversal setup allows traders to trade a reversal setup with a better win probability.
This trading strategy is a reversal trading strategy that trades on a confluence of divergences and price action using a custom oscillator called the Chandes Quick Stick and the Patterns on Chart indicators.
Divergences as Reversal Setups
Price action tends to have a natural cycle of oscillations as the price moves up and down the price chart. It usually moves in a wave-like pattern wherein the price pulses up and down forming peaks and dips. These peaks are what we call swing highs, while the dips are what we call the swing lows.
Oscillator type of indicators typically mimic the movement of price action. These are either presented as lines or bars that oscillate on their indicator window. Since oscillators often mimic the movements of price action, they also tend to have peaks and dips that coincide with the swing highs and swing lows of price action.
Oftentimes, the intensity of the peaks and dips of an oscillator would also be similar to that of price action. However, there are times when the intensity of the peaks or dips of an oscillator would differ from the swing highs and swing lows of price action. Tall swing highs might be matched with a short peak on the oscillator or vice versa. Deep swing lows on price action might also be matched with a shallow dip on an oscillator or vice versa. These are what we call divergences. Such divergences can often be an indication of a potential reversal on the trajectory of price action.
Below are the different types of divergences.
Chandes Quick Stick (Qstick) Indicator
The Chandes Quick Stick (Qstick) Indicator is an oscillator type of indicator developed by Tushar Chande.
The Qstick Indicator plots a line that freely oscillates around its midline, which is zero. This line indicates whether the majority of the candles are bullish or bearish. It plots the line above zero whenever it detects that the majority of the candles for that given period are bullish. Inversely, it also plots its line below zero whenever it detects that the majority of the candles for a period are bearish.
The color of the line it plots also changes depending on whether the line is angling up or down. It plots a sky blue line whenever the line is on an upward slope, and sandy brown whenever the line is on a downward slope.
There are several ways to interpret the Qstick line. Changes in the slope of the line could indicate a change in the momentum direction. Trend direction can also be identified based on whether the line is positive or negative. Crossovers above or below zero could also indicate a trend reversal. Lastly, the Qstick line can also be used for identifying reversal trading opportunities based on divergences.
Patterns on Chart Indicator
Reversal candlestick patterns can be effective trend or momentum reversal signals. This is because candlestick patterns can tell us how the market reacted at different price points and can show us points on the price chart where there are price rejections which can lead to a reversal.
The Patterns on Chart indicator is a custom technical indicator that automatically identifies different types of reversal candlestick patterns. It automatically labels the patterns with its shorthand names so that traders can easily identify the type of pattern that is formed. The equivalent pattern name is also displayed on the upper left corner of the chart for easier reference.
Not all candlestick pattern signals would result in a reversal. However, when these signals are in confluence with other reversal trade setups or when they occur on major support or resistance levels, these reversal candlestick signals can be very effective.
Trading Strategy Concept
This trading strategy is a reversal trading strategy that is based on divergences and confirms trade entries based on candlestick patterns.
The Qstick Indicator is used as the oscillator line which we will compare price action with for us to observe for potential divergences. This is done by comparing the peaks and dips on the Qstick line with the swing highs and swing lows on price action.
The Patterns on Chart Indicator is used to help us objectively identify reversal candlestick patterns and to help us anticipate potential swing highs and swing lows, as well as the actual reversal. However, not all patterns will be used. We will modify the indicator to detect only Shooting Star, Bullish Hammer, and Engulfing Patterns.
Trade signals are then confirmed based on the changing of the color of the Qstick line in confluence with the divergence pattern and the candlestick pattern.
Buy Trade Setup
Entry
- A bullish divergence should be observable between the price chart and the Qstick oscillator.
- The Patterns on Chart Indicator should identify a bullish reversal signal.
- The Qstick line should change to sky blue.
- Open a buy order on the confluence of these signals.
Stop Loss
- Set the stop loss on the support below the entry candle.
Exit
- Close the trade as soon as the Qstick line changes to sandy brown.
Sell Trade Setup
Entry
- A bearish divergence should be observable between the price chart and the Qstick oscillator.
- The Patterns on Chart Indicator should identify a bearish reversal signal.
- The Qstick line should change to sandy brown.
- Open a sell order on the confluence of these signals.
Stop Loss
- Set the stop loss on the resistance above the entry candle.
Exit
- Close the trade as soon as the Qstick line changes to sky blue.
Conclusion
Divergences are valid reversal trade setups that many profitable traders also use. Oscillators that are suitable for divergences do tend to produce reliable reversal trade setups and since they are reversal trade setups, they also tend to produce trades with good risk-reward ratios. This strategy uses an indicator that is viable for trading divergences with a decent trade probability.
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