What is the risk reversal strategy in Forex
The risk reversal strategy is a trading methodology that involves a controlled reversal of position when the market breaks certain technical levels or generates signals of a trend change. In other words, instead of simply closing a losing or winning position, the trader "
flips" it and assumes a contrary exposure. The goal is clear: to exploit the new movement.
The reversal occurs, or should occur, only when
predefined conditions are met, often related to:
- Breakout of a support or resistance level
- Violation of a period high/low
- Reversal of technical indicators (e.g., moving averages, MACD, RSI)
- Sudden changes in sentiment or macroeconomic data
But let's delve into this strategy and explain how it works.
It starts from
an initial position, long or short, opened based on a preliminary market analysis. As long as the price moves in line with the forecast, the trade remains open. However, if the market reaches a key level that negates the initial view, instead of merely closing the position, the trader performs the "reversal"
by transforming it in the opposite direction.
For example, if one is long on EUR/USD and the price breaks down an important support, the exit from the long position is accompanied
by the immediate opening of a short position. This change of direction allows to exploit breakouts or reversals without wasting time and to recover initial losses more quickly.
The strategy offers some advantages over other strategies.
The main advantage of risk reversal is
operational continuity. Instead of waiting for a new setup after an exit, one always remains aligned with the dominant market direction. This can result in greater exploitation of trends and a reduction in periods when capital remains inactive.
Another strength is
dynamic risk management. Since the reversal is triggered at key levels, the trader is able to
quickly reduce exposure in the wrong direction, limiting losses and transforming a potential drawdown into a profit opportunity.
Finally, risk reversal
reduces the emotional impact of sudden reversals, because the action of "turning around" is part of the plan and not a decision dictated by fear or greed.
When to apply risk reversal
Like any strategy, reversal is especially suited to certain conditions. For example, it adapts well to markets characterized by sharp directional movements or strong reactions to key levels. Specifically, it is particularly useful in three contexts:
- Breakout of support or resistance levels: that is, when the price exceeds an important threshold. Thanks to the reversal, the probability of continuation increases.
- Sentiment changes due to macro news: the reference is to the publication of unexpected economic data or central bank statements, which can quickly overturn expectations, making an immediate change of direction appropriate.
- Phases of high volatility: when the market moves in wide ranges, switching from long to short (and vice versa) based on well-defined triggers can be more effective than standing still.
How to set up the strategy step by step
But now let's see how to use risk reversal, step by step.
- Define the key levels. Before opening any operation, it is necessary to identify the points beyond which the initial view is no longer valid. These levels can be recent highs/lows, support/resistance areas, or values derived from technical indicators.
- Establish the initial direction. The operation starts in the direction of the identified trend or technical setup. For example, if EUR/USD shows a sequence of increasing highs and breaks through a resistance, a long can be opened.
- Set the reversal trigger. The trigger is the point where the position is closed and reversed. It can coincide with the original stop-loss or be placed slightly beyond to filter out false signals.
- Manage the new position. After the reversal, the same management rules apply: identification of targets, trailing stops, and monitoring of new invalidation levels.
But let's make
a practical example.
Suppose GBP/USD has been rising for several days and breaks out above a resistance at 1.2800. A long position is opened with a stop-loss at 1.2750. After a few hours, the price reverses and falls to 1.2745, violating the stop level.
With risk reversal, instead of simply closing the long,
a short is immediately opened. The break of support signals a momentum reversal, and the new position benefits from the subsequent downward movement.
If the exchange rate drops to 1.2680, the short gain offsets and may exceed the initial long loss.
