The focus of this post is to locate reversal patterns WITH the trend. Specifically, we’ll look at chart patterns indicating an emotional response among market participants. A webinar recording discussing what these price patterns look like, and where it makes sense to consider such setups is available here:
When discussing reversal patterns, we‘re looking for an extreme price move within a short timespan, which was rejected at a certain level, only to be pushed back to the area where the bar opened. These are what we call spike patterns
- A BULLISH spike has to have a lower shadow much longer than the candle body and the upper shadow…
- For BEARISH spikes, we want the uppershadow to be much longer than the candle body and the lower shadow
An old Japanese proverb states that: A spike that sticks out is very likely to get hit by a hammer. This points to the fact that these candles are very easy to spot on the charts. Accordingly, there‘s a good chance that a number traders will act on them.
Confirming Reversal Patterns in Higher Timeframes
With the Auction Bars indicator, you may filter reversal patterns using a higher timeframe range. These are called Auction Ranges and represent the current market value area. In the below screenshot, 15 min. bars are used to display reversals at the high and low end on a 240 min. range.
Using higher timeframe ranges, reflect the fact that markets are driven by large players. This simply speaks to the fact that more money traded means more market impact. That’s simply a basic law of supply / demand, a.k.a. the capitalist democracy where there’s one vote per contract, not one vote per trader.
Therefore, choosing favorable reversal setups boils down to whether institutional traders are likely to participate. Obviously you‘re more likely to see significant price movement if the big players are in on it.
Aligning Reversal Setups with VWAP Value and the Swing Trend
From an institutional perspective, a major challenge is keeping execution costs in check. They don’t want to move the market and have to avoid front running when entering large positions. Therefore, they’re looking for areas where the majority of the day or week’s transactions are likely to occur. You may locate this area by using the Volume Weighted Average Price (VWAP). Statistically, 70% of all transactions will occur within 1 StDev from the VWAP outlining an area where they’ll find ample supply and demand.
Above, we‘ve zoomed in on a 5 min chart, adding the Auction Bars indicator to show how a bullish reversal pattern aligned with the lower end of a 60 min Auction Range. Furthermore, the Auction Bars indicator comes with a basic ZigZag indicator. You may then filter reversal patterns to plot only in the direction of the current swing trend, in this case a higher low. Finally, we see that the setup aligns within the 1st standard deviation area of the daily VWAP.
Higher timeframe VWAPs may also be used to define an area where institutional investors are likely to participate. Our VWAP Suite includes weekly, monthly, quarterly and annual readings. As opposed to the daily VWAP above, these VWAP readings will be anchored at each session start, i.e. start of the week / month / quarter / year.
The above weekly VWAP is anchored at the full session start of the week. 60 min NQ. On Mondays the Current Week VWAP will therefore display the same information as the Current Day VWAP, anchored at the start of the full session. Readings of the Current Week VWAP can therefore at the earliest start from Tues. on. Accordingly, the limitation with all anchored VWAPs is that you have to wait for them to put on enough weight, in order to make useful readings.
Aligning Reversal Patterns with Rolling VWAP Value
Therefore, we’ve added a Rolling VWAP to our professional VWAP package. It creates a continuous VWAP calculation, i.e. a moving window, taking data from the previous session, moving it forwards.
Below is a 5 day rolling VWAP, again NQ on a 60 min bars and we see the sharp down move on Mon. / Tues. occurred within the weekly value area. Also, we see support at the first test of the Rolling 5 day VWAP and later, a re-test at resistance following the break below.
If we repeat the same exercise with a Monthly VWAP, anchored at the start of the month, we encounter the same limitation. It is identical to a weekly VWAP during the first week of the month. Readings of the current month VWAP can therefore at the earliest start once from the second week on.
The bullish reversal in the 120 min. NQ chart below, plotting at the mid-line of the daily Auction Range has a nice run up to the 2nd standard deviation band, but we‘re still the first week of the monthly session. Also, consider that the trade confirms outside value. Therefore, if you have a system requirement stating that price has to be within monthly value, this would not trigger.
However, by looking at the same scenario with a Rolling VWAP of 21 days (referring to the average number of trading days in a month), we have a reliable value reading at the beginning of the month. Furthermore, the confirmation now plots within monthly value. A system requirement would therefore see this as a valid directional, inside-out reversal pattern setup.
Conclusion:
In general, there’s too much effort put into picking tops and bottoms when evaluating reversal patterns. This post outlined how one may improve the probabilities of these setups by using swing trend analysis and VWAP value. First, by setting the Auction Bars Zigzag filter to only consider reversal setups that align WITH the overall market structure. Second, VWAP value readings can be used to determine whether institutional traders are likely to participate in the trade.
For more information on the Auction Bars and the professional VWAP Suite, check out our Product Page.
