How do you Recognize a Reversal?

The capital markets are made up of people trading securities at different times and for different reasons. The ebb and flow are very important if you are looking to speculate on the direction of an asset such as a currency pair or stock. Most securities trade within multiple types of trading environment which include trends, consolidation, where market volatility is low as well as high. If you are looking to find a period when an asset is likely to reverse and change direction you could consider walking through a reversal checklist to determine if the trend will stop and reverse or continue.

Your checklist should start by first determining your timeframe relative to the risk you are willing to assume. If you have a long time horizon and are attempting to catch a large move in a stock or currency pair you may need to evaluate prices that are both daily, and weekly and in some cases even monthly. If instead you are looking for a short term change in price because you believe an asset is either overbought or oversold, then you might consider daily and intra-day changes.

Once you decided on a time horizon, you want to consider how you should evaluate the recent changes to price action. You can evaluate patterns that a security is creating, you can use studies that will help you analyze the rate of change and momentum, and you can attempt to analyze sentiment which may help you determine if prices are about to change direction.

Reversal Patterns

One of the most well-known reversal patterns is the head and shoulder pattern. The pattern gets its name from the shape that it creates over the course of time. You can see a left shoulder, and head and a right shoulder and when the pattern is finished forming the reversal takes place with a break of the neckline and heavy increases in volume.

While the head and shoulder pattern generally forms at the end of an uptrend, the reverse head and shoulder pattern usually signifies the end of a downturn. The head and shoulder and reverse head and shoulder patterns are no more than a consolidation in price action that comes at the end of the trend. The reason it forms is that indecision arises creating choppy market conditions, which eventually generate a reversal pattern.

The left shoulder of the pattern coincides with the largest market volume as it is the first time in the trend that many people are beginning to take profit, while other are using the dip in prices to enter into a trend. The supply from profit takers or those who are shorting forms the basis of resistance which pushes the market lower. The dip is met by demand pushing prices higher and rounding out the left shoulder. As prices rise to a fresh high above the left shoulder, volume declines as a new top is formed and creates a picture of a head. Resistance forms as volume peters out moving down to a neckline and rounding out the head formation.

After moving lower and hitting support, which forms the neckline, buyers return and ultimately push through to a new intermediate higher which fails to break resistance created by the head. The right shoulder is now formed, and volume is even less as the market moves higher. The head and shoulder pattern is complete when the market breaks the neckline, and volume accelerates as those who bought on the break of the left should peak rush to exit the market.

Oscillators

An oscillator such as the relative strength index (RSI) measures the rate of change of a security over a specific period of time. If then uses that change to compare it to the changes to a period in the past. This calculation of rate of change is then used to form an index from 1-100. The higher the number the greater the rate of change.

The RSI is used by many traders to evaluate whether the price of a security is either overbought or oversold. If the ‘up’ rate of change is much faster than in previous period, the RSI will rise. Index readings on the RSI above 70 are considered overbought. If the rate of change is much faster for ‘down’ movements than a period in the past, the RSI will decline. Readings below 30 on the RSI are considered oversold.

The chart of gold shows periods when the RSI was printing a reading that was oversold in December, and shows a period when gold prices were considered overbought in February. The RSI alone will not give you a specific signal to buy or sell, but what it will do is tell you that the security that you are evaluating is paused for a reversal. When the RSI moved out of oversold territory and it is declining that is usually a sign that the market is reversing. That is also the same when a RSI reading was sold and is now accelerating higher.

Sentiment is also important to evaluate. Overbought levels tell you that the market is overextended to the upside and the reverse is true for oversold levels. Option premiums can also help determine sentiment. When premiums are very high because traders are fearful of a large move in a security, a reversal is likely to occur. When premiums are very cheap sentiment is generally complacent which can also lead to a reversal.

In closing it is key to evaluate many aspects of a market before you determine if it is ripe for a reversal. Most securities trade within multiple types of trading environment which include trends, consolidation, where market volatility is low as well as high. If you are looking to find a period when an asset is likely to reverse and change direction you may consider walking through a reversal checklist such as finding patterns, evaluating oscillators and analyzing sentiment before you pull the trigger.

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