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Spotting a Reversal: Technical Analysis Primer - 43753 views
BALTIMORE (Stockpickr) -- If you’ve been exposed to the main ideas behind technical analysis, you already know that trend is one of the cornerstones of technical trading. Studies have shown that prices move in trends -- and that following those trends is one of the most effective ways to significantly grow your portfolio.
But trends ultimately fail, leaving latecomers holding the bag for those who were prescient (or lucky) enough to get out early. The key to being one of the latter is to spot reversals early.
Of course, as with most stock trading tactics, spotting reversals is much easier said than done. Today, we’ll take a look at some tools that can help you spot reversals early and spare your portfolio from losses.
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The Challenges of Spotting a Reversal
Simply put, a reversal occurs when a stock changes trend and starts to move in the opposite direction of previous price action. Psychologically, reversals can incredibly difficult for even the most experienced investors to react to. That’s because in the early stages of a reversal, the market’s still showing many indications of a continued move in the original direction.
The market meltdown of 2008 was a good example of a powerful downtrend that was difficult to spot the end of. While the lows of March 2009 are easy to spot with the benefit of hindsight, it was considerably more difficult to go long stocks in 2009 after the market had already punished bulls so fiercely in the preceding year.
But by the time skittish mainstream investors had piled onto the stock-buying game, a significant chunk of the market’s initial move was already behind it. Improving reversal recognition is one remedy for that.
Naturally, markets aren’t always trending -- quite often, markets can trade without a discernable direction. Spotting reversals in ranging markets is important too; not only can reversals tell you when a major trend may be about to begin, they also can be a shorter-term trading opportunity for more active traders.
Tools to Use in Identifying Reversals Ahead of Time
One of the most effective tools for spotting a reversal is also the most simple: the trend line. A trend line connects intermediate lows or highs of a stock -- in an uptrend, it connects lows (or troughs), while in a downtrend it connects peaks. If share prices punch through a trend line, the trend may well be broken.
As with most technical tools, trend lines aren’t set in stone. They’re subject to adjustment as a stock’s price action works itself out. So a trend line break in a bull market may not in and of itself signal the start of a major secular downtrend. That said, more often than not, trend line breaks signal intermediate reversals at the very least. These can be played profitably with more than a little experience.
Oscillators are another tool that are used frequently to help spot reversals. Oscillators are indicators that are banded between two extreme numbers or have a base value. Typically, they are momentum indicators, and can signal overbought or oversold conditions when they’re at extremes. Common oscillators include RSI, MACD and stochastics. Don’t be fooled into common practice with oscillators -- while a move to oversold or overbought territory does indicate a reversal could be forthcoming, it’s actually quite common for stocks to keep running as momentum continues to accelerate.
Instead, use oscillators alongside other indicators for the best chances of spotting a reversal. Watching out for a negative divergence between share price and RSI, or a bearish crossover in the MACD, for example, are two indicators that the market is topping.
Economic data can also be a good indicator (contrarian or otherwise) of a top or bottom in the stock market. Remember, the crowd is typically wrong; high levels of pessimism or optimism generally indicate that the market is headed for a reversal to the other direction. When looking at sentiment data alongside prices, it’s crucial to look at enough data to get a glimpse of where sentiment has historically stood through several previous market cycles -- otherwise, you may not have a full picture of which sentiment numbers are significant.
Increasing Profitability on Reversal Bets
Because spotting reversals isn’t foolproof, it’s important to use smart risk management techniques to avoid getting hammered if a potential reversal fails. The easiest way to do this is with well-placed stop losses (hard or otherwise) just inside the stock’s trend line. Don’t ever try to “top tick” a reversal by betting against stocks while they’re still in uptrend mode -- waiting for the reversal to actually occur, then capturing the meat of the move, is a significantly more profitable strategy.
While spotting reversals early can significantly improve your ability to profit in both bull and bear markets, it’s likely one of the most difficult (and sought after) skills to master in technical analysis. As with most disciplines, practice is key. Next week, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
-- Written by Jonas Elmerraji in Baltimore.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.