The Reversal Candle

It’s not uncommon to see a candle with a long wick appear at the high or low of a price move. Often that’s a great opportunity to initiate a position but how do I know if that candle is a true reversal or not? The answer is that I don’t as of the close of that same candle so I look for validation of the reversal on the following or future candles (this post is based on the weekly chart but the same principle applies to all time frames). If the following/future candle reacts to the HB zone of the reversal candle I can then trade from that setup. First, I have to define HB zone. The HB zone is the area between the 50% retracement (Half-Back or HB) and the 61.8% retracement of a prior price range. If a potential bullish reversal candle appears after a price decline then the HB zone is measured from the bottom of the price range to the top. If a potential bearish reversal candle appears after a price increase then the HB zone is measured from the top of the price range to the bottom. On the chart below I’ve put a red box around the bullish weekly reversal candle on SPX that occurred on the week of 7/19/21. The following week’s low remained well above the HB zone offering no opportunity to get long using the HB zone strategy. As is often the case, the patient trader is rewarded with great opportunities! The week’s of 9/20, 9/27 and 10/4 (labeled as red #’s 1-3) allowed trader’s to enter long within the 4302-4324 area. The largest drawdown of 24 points below the bottom of the zone occurred during the week of 10/4. The stop on the long trade was the low of the anchor candle which was 4233. Price never came closer than 45 points of triggering the stop. Price then rallied 415 points over the next 4 weeks.

Fast forward to the week of 10/4/21. That candle was a potential bullish reversal as of the close of that weekly candle. So you had a new potential bullish reversal candle forming within the HB zone of the 7/19 bullish reversal. Let’s put a HB zone on that 10/4 weekly candle and see what happens. The following week’s (10/11) candle low of 4330 was just 7 points below the bottom of the 4337-54 HB zone. The 4-week rally following that 4330 low was 381 points. Once again, the low of the anchor candle was the stop on the long trade and was never in danger of being triggered.

Now we fast forward to the current week that just completed. This week’s candle is clearly a potential bullish reversal candle. The HB zone of this week’s candle is 4336-54. The low of this week’s candle is 4222. The HB zone strategy would be for me to buy a long position between 4336-54 with a 4222 sell stop. Wow, that’s a big range for a stop! It is but price has been moving 1%-2% daily so trading in the current environment must adjust to that volatility. There are numerous option strategies discussed within this blog (such as an OTM Butterfly or Condor) that allows me to limit my capital risk while still allowing for a good reward/risk ratio utilizing the HB zone price strategy.

I mentioned that this same reversal setup appears on all timeframes and that is true. Below is a 15-minute chart of /ES. All of the same principles apply.

Before I wrap up this post I want to highlight one more price clue and show you a few additional charts below which should help you understand price action a little better. First, you may have noticed on the previous charts that there is a yellow line that was near the low of the candle on the weekly chart and near the high after the bullish reversal on the 15-minute chart. In fact, you could look at the price action and surmise that perhaps price reversed near that yellow line because of that yellow line. 🤔 What is it? On my charts I have the important pivots of prior time periods. Those pivots are the high, low and HB (midpoint) of a prior range. I watch the daily, weekly, monthly and yearly pivots. The high and low of those periods are obviously important but what’s the importance of HB? I use HB as a proxy for the fair value of a prior period’s range. It’s often an area where both buyer’s and seller’s are comfortable holding their positions. Price typically has an easier time moving towards HB than it does moving away from it. When price is moving away from HB that is a sign of strong motivation! So, what was that yellow dashed line on the weekly chart? That was last year’s HB in SPX. The long-term buyer should be reasonably comfortable buying there and, in fact, anyone this week who bought last year’s HB had a drawdown of just 23 points and is now 197 points up on their trade. That line can be treated as an important long-term bull/bear line. As long as price is above last year’s HB the next long-term target is a return to last year’s high and if price is below last year’s HB then the long-term target is a return to last year’s low. Again, those are long-term targets and I won’t be placing specific trades around those pivots but it helps me keep the longer-term trends in mind when I’m trading the daily and hourly charts.

Below are some additional charts that should help you see the reversal pattern more clearly including an example of when it’s less likely to be a true reversal.