Forex trading reversals and pullbacks: what are they, and how can you use them?

Featured article by Paul Bailey, Independent Technology Author

One of the most important skills that a forex trader can acquire and develop is an awareness of when, where and how market trends happen. Being able to develop this skill can have a serious impact on your forex trading portfolio.

If you can be responsive to the regular forex news that comes out on a daily basis, you will be able to spot opportunities to turn a profit or, equally importantly, moments at which you might suffer a loss.

As you can see, then, being able to identify and respond to market trends as they happen in real time is an incredibly important skill to have.

With that said, two common phrases you might have come across over the course of your forex trading career are ‘reversals’ and ‘pullbacks.’ These are technical terms used by traders to describe two distinct market trends. What are they and, more importantly, why do they matter?

What is a ‘reversal’?

When traders and market analysts refer to a ‘reversal’ happening in the markets, this basically means that the trend direction the financial instrument in question was heading has suddenly changed – most often in the opposite direction. This reversal can happen in a number of directions and can have both positive and negative implications for your trading portfolio.

Why do reversals matter?

Reversals can come in a number of different formulations. A positive trend reversal could see you earning a profit on a particular trade, while a negative trend reversal could see the opposite happen. If you fail to spot a negative reversal – i.e. when the price that was previously moving up in value suddenly goes downward – this could see your profitability on that trade diminish or evaporate entirely. As such, being able to spot a reversal either as it happens or, preferably, before it happens can prevent these losses from occurring and limit your overall risk exposure. A good way of protecting yourself from the negative effects of trend reversals is to use a stop loss order to close a position if the price starts to dip too low.

What is a ‘pullback’?

In the same way that a reversal refers to a change in the trend of a particular asset or instrument, a ‘pullback’ refers to a pause or moderate drop in the market. As with retracement or consolidation, the term ‘pullback’ usually gets used when the pricing drops are relatively short term in duration. In this sense, a pullback will usually happen just before a ‘reversal’ trend establishes itself.

Why should I be worried about pullbacks?

Much like reversals, pullbacks are a strong signal that the market conditions are beginning to change. As pullbacks usually happen before reversals settle in, they are arguably a more important signal to look out for. However, it should be noted that the very nature of pullbacks makes them more difficult to spot than reversals as it will not always be fully clear if a pullback is actually happening or if it is just more general market volatility.

How can I use reversals and pullbacks to my advantage?

Although they technically capture distinct market trends, in certain respects, reversals and pullbacks are important for forex traders for many of the same reasons.

This is because, in certain circumstances, both reversals and pullbacks will signal either buying or selling opportunities depending on the direction of the trend. By spotting pullback and reversal trends as they happen in real time, you will be able to use these as signals for when you should open or close a position. A negative reversal trend, for example, might signal that the value of a particular asset is decreasing and that you need to close your trading position before you lose any more value. On the other hand, the same reversal trend might signal that now is a good time to acquire a particular asset given that the value is, momentarily, decreasing. Similarly, an upward reversal trend would be a good signal that now is the time to sell, or that it might be coming along soon, if you hope to lock in your profit on a particular position.

As you can see, whether or not a reversal or a pullback indicator can be used to your advantage will depend entirely on the underlying market conditions and what trades you have open when the trends happen. What is certain, however, is that both reversals and pullbacks can be used to your advantage no matter your forex trading strategy. Spotting these trends and understanding how to use them to your advantage will, therefore, be an important element of any successful forex trading strategy.