Clarity is the boon of all successful stock traders. When navigating the volatile waters of stock trading, experienced traders will often look for signals to validate the strength of market sentiment and any prevailing price action movement. The clearer the signal, the better the quality of the trade will be. In the deep arsenal of a trader's toolkit, one of the most effective validation signal techniques used is the Role Reversal.
What is a Role Reversal Pattern?
A Role reversal refers to a key technical analysis concept wherein a previous resistance level becomes the new support after a breakout and where a previous support level becomes the new resistance level after a breakdown. This shift confirms a significant change in market sentiment between buyers and sellers, which often reinforces the strength of the previous breakout or breakdown.
We can find a role reversal signal in either bullish or bearish price structures.
Bullish Role Reversal
A bullish role reversal happens when a previous key resistance level now acts as a key support after a major breakout.
Bearish Role Reversal
A bearish role reversal happens when a previous key support level now acts as a key resistance after a major breakdown.
ANALYZING A BULLISH ROLE REVERSAL SIGNAL
A bullish Role Reversal signal validates a previous price breakout. As the price pulls back from a fresh breakout, profit taking is quickly absorbed by increasing demand until it bounces at the previous resistance and rallies.
This type of Role Reversal will exhibit the following price action components:
An initial major breakout with above average volume must have happened
Price pulls back with lowering volume
Price bounces at the previous resistance level turning it to a new major support
Higher high candle after the bounce continuing the rally
The chart above shows a classic bullish Role Reversal signal. Notice that the first phase of the pattern is a valid breakout move with increasing volume. After the breakout, there is usually some form of pullback or consolidation that will retest the previous resistance as the new support. Once the price has successfully bounced, this signal validates the overwhelming strength of the buyers and signifies that the price will continue to rally.
ANALYZING A BEARISH ROLE REVERSAL SIGNAL
A bearish Role Reversal signal validates a previous price breakdown. As the price recovers from a fresh breakdown, momentary buying is quickly absorbed by increasing profit taking until it gets rejected at the previous support and falls deeper.
This type of Role Reversal will exhibit the following price action components:
An initial major breakdown with above average volume must have happened
Price bounces and recovers with lowering volume
Price gets rejected at the previous support level turning it to a new major resistance
Lower low candle after the rejection continuing the retracement
The chart above shows a classic bearish Role Reversal signal. Notice that the first phase of the pattern is a valid breakdown move with above average volume. After the breakdown, there is usually some form of technical bounce that will retest the previous support as the new resistance. Once fully rejected, this signal validates the overwhelming strength of the sellers and signifies that the price will continue to fall.
Role Reversal Pattern as a Momentum Entry Signal
One of the main uses of Role Reversal patterns is to serve as an entry signal during momentum setups. When price breaks out, there are times wherein the price will not continually go up due to RSI already being at highly overbought levels. As such, a pullback happens. This is the time wherein momentum traders will look for a pullback entry through a Role Reversal pattern. Also, if traders miss the exact point of breakout, a Role Reversal bounce serves as the next low risk entry level to ride the momentum move.
In a long position, there are two general ways to utilize Role Reversal as buy/entry signals:
Role Reversal entry through standard support/resistance plotting
In the chart above, you'll notice the key resistance level being respected for the months of October - December 2021. But on January 2022, a notable breakout move happens accompanied by above average volume. As the price continues to move up, a pullback formation happens. If the pullback is accompanied by lowering volume, momentum traders will wait and monitor how it behaves when it reaches the previous resistance level. If the price bounces at the previous resistance, it will now reverse its role as the new support, hence the Role Reversal pattern. As this happens, momentum traders can buy and ride the incoming rally.
Role Reversal entry through moving averages
In the chart above, you'll notice the key resistance level is not a plotted horizontal line. Instead, it is the Moving Average (MA) 200 line serving as the previous resistance level. Once the price breaks out past the MA200 line, RSI reaches 80 and pulls back. As it pulls back, it bounces above MA200 thereby reversing its role from resistance to support. Momentum traders can buy during this Role Reversal bounce and ride the incoming rally.
In a Nutshell
Role Reversal signals provide traders with the clarity needed to validate price action movements. Understanding this will allow a trader to properly determine the right course of action when a breakout or breakdown happens. Successful application of this will eliminate impulsive trade decisions, paving the way for confident and precise execution.
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