Traders Toolbox: Reversals

Reversals In my opinion, one of the most misused and abused terms in technical analysis is the reversal or key reversal. I often get calls from both new and experienced traders who are excited about a market because it has just posted a "key reversal." While the action these traders point to often marks a reversal day, such a day (week or month) by itself actually has little significance. There is research which indicates single period reversals mark a turn only about 50% of the time. Which gives about the same odds of indicating a turn using a coin flip.

In my studies, I use a set of rules which help me ferret out reversals which have a much higher probability of marking a turn. Before going any further, I want to clarify the term reversal when used in technical analysis. A reversal does not mean a market will necessarily reverse a trend. A reversal is a formation which may mark a top or a bottom. However, a top or bottom only signals the preceding trend has come to an end. In other words, a top will indicate an uptrend has come to an end. It does not indicate whether the new trend will be down or sideways.

Now, on to the rules. There are six rules which I use to identify a valid reversal. To clarify these rules, I have provided an example of the pattern which I watch for to mark a reversal in the circle on the weekly T- bond chart. I am listing the six rules to identify a reversal high; for a reversal low, simply reverse the parameters where warranted.

To mark a reversal high, first, the market must make a new high for the last six to eight weeks. Second, the market must close lower than the previous day's (or week's) close. Third, the market must reverse the previous day's (or week's) action. To clarify rule three, the day or week preceding the reversal must have posted a positive close. Fourth, the market must post follow through action the next day (or week). Again, to clarify, the market must close lower on the day (or week) following the reversal. Fifth, the reversal must be accompanied by moderate to high volume. And, finally, the reversal must occur in a terminal (critical) area.

Rules one through four deal with the pattern which the market must trace out and are basically self-explanatory. Rule five insures the reversal is not marked on a low-volume day (or week) such as is common in a holiday period. And rule six essentially means the market must be in an area of price or time where a turn could be expected to occur.

Notice the weekly T-bonds chart and the numerous turns which were marked by the valid reversal pattern. If you examine the chart closely, you will notice there are a number of reversal weeks which did not see followthrough action which failed to turn the market. However, it is rare to find a reversal which saw followthrough action that failed to mark a significant turn.

7 thoughts on “Traders Toolbox: Reversals

  1. I agree with your very nice explanation. And I think I can add some little improvement.

    By my experience, it is very often situation that entering on second reversal is much appropriate than entering the position on the first reversal. It can be seen on your charts too. Consequently, on the second reversal I tend to risk more and I tend to make bigger take profits (TP), bigger targets than entering on the first reversal.

  2. Your method is ok except that by the time you get your confirmation the move is frequently 1/2 to 2/3 or more finished and your stop is too great to enter except possibly after an up move.

  3. This is one of the key learnings in interpreting a chart. There are no many works which would describe all these conditions in one shot. Therefore, somebody would need to experience them one by one and learn the hard way. This description is cristal clear: straightforward, simple terms and still comprehensive. A typical Market Club supply.
    Thanks for it and all the best!

  4. These are awesome rules. I put together a quick stock screen in and came up with great examples of stocks that recently met these rules. Check out sqnm, ezpw, and rbn. SQNM to me fits all 6 rules perfectly, and took less than 5 minutes to find.

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