Let’s be honest. Trying to short a stock that’s gone parabolic feels like standing in front of a freight train. And buying a stock that’s been dumping for six straight months? That’s called trying to catch a falling knife, and our hands are full of scars from when we were new to this. This is the hardest game within the game: calling a market turn.
Every new trader is looking for that one magic indicator that screams “THE TOP IS IN!” or “THIS IS THE ABSOLUTE BOTTOM!” We were too. We spent years looking for it. Plot twist: it doesn’t exist.
Success with a reversal trading strategy isn’t about finding one perfect signal. It’s about being a detective. It’s about gathering clues, stacking evidence, and building a case so compelling that taking the trade is the only logical conclusion. This is our playbook for how we do it.
Stop Guessing, Start Building a Case for a Reversal
First thing’s first. A reversal is not a pullback. A pullback is a brief pause, a little breather, in a continuing trend. A reversal is the end of that trend and the start of a new one in the opposite direction. One is a pit stop, the other is turning the car around and driving back home.
Our team learned the hard way that you can’t just short a stock because the RSI is overbought. That’s a recipe for blowing up your account. We had to change our entire mindset.
Instead of looking for a reason to enter, we started looking for a story. A story of trend exhaustion. Of conviction fading. Of the “last buyer” finally buying at the top or the “last seller” finally puking their shares at the bottom. This story is told through a combination of factors. No single clue is enough. But when you get three or four… that’s when we get interested.
Exactly.
The 4 Pillars of Our Reversal Playbook (The Evidence)
Think of yourself as a prosecutor. You can’t convict with just one piece of flimsy evidence. You need a chart pattern, you need a momentum shift, you need candlestick confirmation, and you need the volume to back it all up.
Pillar 1: The Chart Tells a Story (Classic Reversal Patterns)
This is your foundational evidence. These are the classic shapes that have appeared on charts for over a century because they represent the psychology of a turning point. We’re not going to list all of them, but these are our go-to patterns.
- Head and Shoulders (for Tops) / Inverse Head and Shoulders (for Bottoms): This is the king of reversal patterns. It shows a clear story: The bulls try to make a new high and succeed (the left shoulder). They try again and push even higher, but the momentum is weaker (the head). Their final attempt to rally fails at a lower high (the right shoulder). It’s a story of failure, and the break of the “neckline” is the prosecution’s closing argument.
- Double Tops & Double Bottoms (“M” and “W” patterns): Simpler, but just as powerful. A stock makes a high, pulls back, and then tries to re-take that high but can’t. That second failure is everything. It tells you the buying power that got it there the first time has vanished. A Double Bottom is the same, just flipped—the sellers try twice to push the stock to a new low, and they fail. We’ve seen some of our biggest wins trading a confirmed “W” bottom.
These patterns are the scene of the crime. They establish that something is wrong with the trend.
Pillar 2: Price is Lying (Indicator Divergence)
Here’s the kicker. Sometimes, price makes a new high, but the momentum behind the price doesn’t. This is called divergence, and it’s like catching the suspect in a lie.
Our favorite tools for this are the RSI (Relative Strength Index) and the MACD.
Bearish Divergence (at a top): The stock price makes a higher high, but the RSI or MACD makes a lower high. It’s screaming that the move is running on fumes.
Bullish Divergence (at a bottom): The stock price makes a lower low, but the RSI or MACD makes a higher low. This tells you the downward momentum is drying up, even as the price makes one last, desperate puke lower.
Honestly, we almost never take a reversal trade without divergence. It’s that important. It’s the subtle clue that most people miss, and it’s one of the earliest warnings you’ll get. It’s a core part of any real contrarian trading strategy.
Pillar 3: The Candles are Whispering (Exhaustion Candlesticks)
If the chart pattern is the crime scene and divergence is the lie, then specific candlestick patterns are the eyewitnesses. You need to see them appear at a key level—like the second peak of a double top, or near a major resistance area.
- Dojis: These are candles with long wicks and tiny bodies. They represent pure indecision. After a long uptrend, seeing a Doji means the buyers and sellers fought to a draw. The conviction is gone.
- Hammers (at bottoms) & Shooting Stars (at tops): These show a massive rejection. A hammer shows sellers tried to push the price way down, but buyers stormed back and closed it near the high. It’s a failed attempt to continue the downtrend.
- Engulfing Candles: A massive bearish engulfing candle at a potential top—where a big red candle completely swallows the prior green candle—is a violent change of character. It’s a statement.
Seeing one of these candles right at the peak or trough of a bigger pattern? That’s a huge piece of confirming evidence.
Pillar 4: Volume Screams the Truth (The Ultimate Tell)
This is it. The pillar that separates our playbook from most of the stuff you’ll read online.
Volume is the truth serum.
At a Bottom: We want to see capitulation volume. This is a massive, sick-looking volume spike on the final low. It represents the moment everyone who was going to sell finally panics and sells all at once. It’s the “get me out at any price” moment. Once they’re all out… who is left to sell?
At a Top: The story is more subtle. We often see volume diminish on the final push higher. Take a Double Top pattern. If the first high was made on huge volume, but the second high is made on weak, pathetic volume… the move is a fraud. There’s no conviction. The big money isn’t participating. Which brings us to volume. Always volume.
A reversal without volume confirmation is sketchy. A reversal with volume confirmation is an A+ setup.
Tools for The Reversal Hunter
Look, you can find these patterns with any decent charting platform. But to do it efficiently, you need the right tools.
- Charting Platform: TradingView is our team’s go-to for manual analysis. The charting tools are clean, and it has every indicator you could possibly need to spot divergence and analyze candles.
- Scanning Software: Finding these setups across thousands of stocks is impossible to do manually. This is where a tool like Trade-Ideas becomes invaluable. We can build custom scans to specifically hunt for stocks making 52-week lows but with a bullish RSI divergence, or stocks with massive volume spikes. It automates the “hunting” part of the process so we can focus on the analysis.
Real Trading Simulation: Calling the PayPal (PYPL) Bottom
Let’s put the playbook into practice. Go look at a chart of PayPal (PYPL) from October 2023. It was a bloodbath. The stock had been falling for what felt like an eternity.
Here’s how the evidence stacked up, pillar by pillar.
- The Story (Chart Pattern): In late October 2023, PYPL made a low right around $50.25. It bounced, then in mid-November, it came back down and tested that same area, making a slightly higher low around $51. This formed a classic—if a bit messy—Double Bottom, or a “W” pattern. This was the scene of the crime.
- The Lie (Divergence): Now, look at the RSI indicator on a daily chart. When PYPL made its lowest price low on October 26th, the RSI made a low. But when price came back down to test that area in November, making a higher low in price, the RSI made a significantly higher low. This was textbook Bullish Divergence. Price was saying “we’re still weak,” but momentum was screaming “the selling is exhausted!”
- The Eyewitness (Candlesticks): On the retest of the low in November, you can see several days of indecision candles and hammers, showing that sellers could not push the price down with any conviction. The buyers were starting to absorb the selling pressure.
- The Truth (Volume): The initial low in October happened on a significant volume spike. That was the capitulation. People gave up. The subsequent retest in November occurred on much lower volume, confirming the selling pressure was exhausted.
The Trade:
- Entry: A conviction entry would be when PYPL broke and held above the midpoint of the “W” pattern, around $56.
- Stop-Loss: A logical stop would be placed below the absolute low of the entire pattern, just under $50.
- Result: The case was solid. The stock never looked back, ripping over 20% in the following months.
This wasn’t a guess. It was a conclusion based on a mountain of evidence.
The Biggest Mistakes Traders Make When Calling Tops & Bottoms
We’ve made all of these. Multiple times.
- Relying on a Single Indicator: “The RSI is overbought, I’m shorting!” We’ve all been there. It’s the single fastest way to lose money. An indicator is just one piece of evidence, and often it’s the weakest one.
- Ignoring Volume: A breakout or breakdown without volume is a trap. We said this before, but it’s worth repeating. If you ignore volume, you’re trading blind.
- Not Waiting for Confirmation: Don’t try to short the exact peak or buy the absolute low. Let the pattern play out a bit. Wait for the neckline of a Head and Shoulders to break. Wait for the midpoint of a Double Bottom to be reclaimed. Being a hero is expensive. Be a patient opportunist instead.
- Fighting a Strong Trend Prematurely: The trend is your friend until the bitter end. Don’t start looking for a top just because a stock has had a huge run. Wait for the evidence—the divergence, the pattern, the volume shift—to actually appear.
Frequently Asked Questions
What is the best indicator for reversals?
There is no single “best” indicator, but RSI and MACD are excellent for spotting momentum divergence, which is a key early warning sign.
Our team thinks of it less as one indicator and more as a combination of clues. Divergence is probably the most crucial leading signal we look for. But price patterns and, most importantly, volume confirmation are what seal the deal. Relying on just one thing is a mistake.
Key Takeaway: Use divergence from RSI or MACD as an alert, not as a standalone entry signal.
How do you know when a stock is about to reverse?
You look for a confluence of events: a classic reversal chart pattern, waning momentum (divergence), key reversal candlesticks, and a significant change in volume.
Honestly, you never “know” for sure. It’s all about probability. When you see a double top forming on declining volume with bearish RSI divergence appearing at the second peak… the probability of a reversal is suddenly very high. You’re stacking the odds in your favor.
Key Takeaway: A reversal is a process, not a single point; wait for multiple signals to align.
What is a high-probability reversal pattern?
The Head and Shoulders (and its inverse) is widely considered one of the most reliable reversal patterns due to the clear story of failure it represents.
That said, a well-formed Double Top or Double Bottom at a significant prior support/resistance level can be just as potent. The key isn’t just the pattern itself, but where it forms and whether the other pillars of evidence (divergence, volume) support it.
Key Takeaway: The Head and Shoulders pattern offers a clear, multi-stage story of a trend failing.
Can you predict a market reversal?
No, you cannot predict a reversal with 100% certainty. The goal is to identify high-probability turning points where the evidence strongly suggests a reversal is likely.
“Predicting” is a dangerous word in trading. We prefer “anticipating.” We see the evidence building, we form a hypothesis, and we define our risk. We’re not fortune tellers; we’re risk managers reacting to an accumulating body of evidence.
Key Takeaway: Don’t predict, anticipate. Build a case based on evidence and manage your risk.
What is the difference between a reversal and a pullback?
A pullback is a temporary, shallow move against the trend, while a reversal is the end of the prior trend and the start of a new, sustained move in the opposite direction.
Think of it like this: If a stock is in a strong uptrend and drops 2-3%, that’s likely a pullback. If it forms a massive Head and Shoulders pattern over two months and breaks its 200-day moving average… that’s a potential reversal. The scale and character are completely different.
Key Takeaway: Pullbacks are minor pauses within a trend; reversals change the trend’s primary direction.
Does divergence always mean a reversal?
No. Divergence can persist for a long time in a strong trend, and it does not guarantee a reversal. It’s a warning sign, not a definitive signal.
This is a classic trap. We’ve seen stocks with bearish divergence grind higher for weeks. It’s a powerful clue, but it MUST be confirmed by a price pattern breaking down. Divergence tells you the trend is sick; a pattern break tells you the trend has died.
Key Takeaway: Divergence is a warning of weakness, but price action must confirm the actual turn.
What is a bottom fishing strategy?
“Bottom fishing” is a colloquial term for trying to buy a stock after a steep decline, hoping to catch the absolute low before it reverses higher.
It’s generally a high-risk strategy unless you apply the evidence-based playbook we’ve outlined. Mindless bottom fishing is how you catch a falling knife. Systematic bottom fishing is identifying bullish divergence, capitulation volume, and a clear reversal pattern to make a calculated entry.
Key Takeaway: Avoid random bottom fishing; use a systematic, evidence-based approach to buy beaten-down stocks.
How does volume confirm a reversal?
At a bottom, a massive volume spike (capitulation) confirms sellers are exhausted. At a top, declining volume on the final new high confirms buyers lack conviction.
Volume is the ultimate truth-teller. A price move on low volume is suspicious. A price move on high volume has conviction behind it. Learning to read the story of volume alongside price is a game-changer and a cornerstone of our volume analysis.
Key Takeaway: Volume validates the price action; it reveals the conviction (or lack thereof) behind a move.
Why is reversal trading so difficult?
It’s difficult because it requires you to trade against the prevailing momentum and market psychology, which is inherently risky and emotionally taxing.
You are betting that an established trend, which everyone else is still following, is about to fail. That’s a tough bet to make. It requires extreme patience to wait for all the evidence to align and extreme discipline to admit when you’re wrong and cut the trade.
Key Takeaway: Reversal trading pits you against the current trend, making it psychologically and strategically challenging.
What are the signs of trend exhaustion?
Key signs include momentum divergence, the formation of reversal chart patterns, the appearance of indecision candlesticks, and a noticeable drop-off in volume on new highs.
Trend exhaustion isn’t one thing; it’s a collection of symptoms. The price might still be inching higher, but underneath the surface, the engine is sputtering. Divergence, weak volume, and Doji candles are all signs the tank is running empty.
Key Takeaway: Look for a cluster of signs—divergence, specific patterns, and weak volume—to spot a trend losing its power.
Conclusion: Your Next Steps
Stop looking for the magic bullet. It isn’t coming.
The real “alpha” in reversal trading comes from discipline. It’s the discipline to develop a checklist based on the pillars in this playbook. The discipline to wait patiently for setups where you can check off three, or ideally all four, of those boxes. And the discipline to walk away when the evidence just isn’t there.
Start by looking at old charts of major market tops and bottoms. Go find the 2022 top in the QQQ or the March 2020 bottom. You will see these clues—divergence, patterns, volume—at almost every major turning point. Study them. Internalize them. Build your own trading plan around them.
That’s how you go from guessing to executing a high-probability reversal trading strategy.
