When a trend moves for an extended period and starts to consolidate, one of two things could happen:
1. The price could continue in the same direction (continuation breakout).
2. The price could reverse in the opposite direction (reversal breakout). There are several ways to tell whether or not a trend seems to be nearing its demise, and a reversal breakout is in order.
MACD
MACD is one of the most common indicators used by forex traders and for a good reason. It is simple yet dependable and can help you find momentum, such as the lack of momentum! MACD can be displayed in several ways, but one of the “sexiest” ways is to look at it as a histogram. This histogram shows the difference between the slow and fast MACD lines. When the histogram gets bigger, it means momentum is getting stronger. When the histogram gets smaller, it means momentum is getting weaker.
RSI
RSI is another momentum indicator that is useful for confirming reversal breakouts. This indicator tells us the changes between higher and lower closing prices for a given period of time. We won’t go into too much detail about it, but if you want to know more, check out our lesson on RSI. RSI can be used similarly to MACD in that it also produces divergences. By spotting these divergences, you can find possible trend reversals.
However, RSI is also suitable for seeing how long a trend has been overbought or oversold. A common indication of an overbought market is if the RSI is above 70. Conversely, a common indication of whether a market is oversold is if the RSI is below 30. Because trends are movements in the same direction for an extended period of time, you will often see RSI move into overbought/oversold territory, depending on the direction of the trend. If a trend has produced oversold or overbought readings for an extended period of time and begins to move back within the range of the RSI, it is a good indication that the trend may be reversing.
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