When trading, investors seek to have the wind at their backs. After all, going with a trend offers a greater chance of profiting than positioning against the market’s collective wisdom. However, just as a ball thrown in the air cannot float higher indefinitely, trends eventually stop.
The basic guidelines of predicting stock trends teach us how to identify when a pattern has ceased. Although a break in a trend is an important data point, it means the time to profit has already passed. Another technical tool is available that can help us get ahead of this move—the reversal.
Reversals are events that dictate the underlying market trend is about to change. While less frequent than some of the other approaches we’ve already reviewed, reversals are powerful and decisive. To begin using them, learn these five assumptions:
1. Existing trends needed –Reversals occur within existing trendlines. While the actual reversal does not indicate the trend has been broken, it lets us know that the trend change is around the corner.
2. Marking a bottom – The bottom reversal indicates a downtrend will soon end. It occurs when a stock opens at a new low, yet closes above the prior day’s close. Looking at ConocoPhillips (COP), the blue arrow indicates the stock opening lower, but then closing above the prior day’s close. This reversal indicated the longstanding downtrend would break and allowed investors to buy the shares $2 below where the trend eventually reversed.
3. Calling a top – A top reversal indicates a stock is preparing to move lower. It occurs when a stock opens higher on the day, yet closes below the prior day’s close. DryShips (DRYS) offers a perfect example of a top reversal. The black arrow indicates a higher open, but lower close. Since that day, the shares have lost nearly 95%. An investor who marked the top via a reversal would have been well served.
4. Volume reinforces – As with most technical patterns, reversals on heavy volume reinforce the movement. Returning to DRYS, the black circle indicates a spike in volume that accompanied the reversal. This should have warned all those owning the shares that the massive reversal was occurring.
5. Time matters – Time is also a data point that is relevant in most technical patterns. Monthly moves supersede weekly moves which supersede daily moves. Most often, we will see reversals on daily charts. On the rare occasions where monthly and weekly reversals occur, extra attention is warranted.
Since great rewards accrue to those who position before a trend develops, every investor seeks a method to divine that moment. Reversals are a key tool that when used properly can allow such positioning to occur.
Sean Hannon, CFA, CFP is a professional fund manager.
Further Education, Technical Analysis: