It sounds simple. A short-term trend runs its course and then turns; prices begin moving in the opposite direction. But in practice, you are faced with a series of failed signals and false leads. Having a short list of reliable reversal signals improves timing, but nothing gives you 100% certainty. The goal here is not to get to 100%, but to improve your averages. Just timing reversal at the best possible moment most of the time is enough to make a day trading or swing trading strategy more profitable.
Short-term traders base their strategy on a three- to five-session short-term trend. By this definition, a trend has to consist of three sessions moving in the same direction. An uptrend must consist of each session’s opening price higher than the previous session, and each closing price also higher: a series of higher lows and higher highs. A downtrend follows the same rules. Each session has to open lower than the previous session, and also has to close lower: a series of lower highs and lower lows.
The theory is that the short-term trend lasts at least three sessions, but can also continue well beyond. So you need a strong reversal signal to know when to exit an open position or to enter a position based on the turn itself. Swing traders look for a few key technical signs for this. Five strong reversal indicators are worth using:
1. Exhaustion gaps. The "exhaustion" gap indicates a movement that actually outpaces actual buyer or seller activity. When the market price moves to quickly (seen with a series of repetitive gapping action over three or more sessions) the most likely next step is a "reverse and fill" price pattern. This is especially the case when the exhaustion gap takes prices above resistance (in an uptrend) or below support (in a downtrend). A true breakout is most likely to build strongly over a series of sessions with indicators like trendlines, reaction to head and shoulders or double top/bottom signals, and other well-recognized technical indicators. When swing traders observe a sudden breakout above resistance or below support through raid price movement and a series of repetitive gaps, the odds of a reverse-and-fill are quite high.
2. Narrow-range days (NRDs). A session with very little space between opening and closing price is an NRD. This occurs at the end of a trend and foreshadows a likely reversal. The pattern (which candlestick chartists called a doji) is easy to spot. In its most extreme form, the rectangular candle is quite small or even a horizontal line with no body. An NRD with a trading range above or below the open/close range further strengthens the NRD. It indicates that neither side (buyers or sellers) was able to move price out of its thing range. When coupled with other end-of-trend signals, the NRD is very strong as a reversal indicator.
3. Volume spikes. Another strong sign of reversal is a volume spike. When you see exceptionally high volume accompanied with other clues, especially the NRD, expect a price reversal. The higher the spike, the greater the chances that a true reversal with happen in the next session. It’s true of all reversal indicators that confirmation is the key, which is why volume spikes combined with gapping action and the NRD are especially strong signals. Narrow-range trading sessions are not uncommon, but volume spikes are; so you are likely to see an NRD in the middle of a trend as well as at the end. In the moment, it is impossible to tell where the trend is in the moment, but when the volume spike and NRD occur together, it probably means the trend is ending and about to reverse.
4. Reversal days. When a short-term trend stops and begins moving in the opposite direction, it is one of several signs that the previous trend is over. But this is a difficult one to call. Some trends last much longer than the three- to five-session swing trading minimum, and may include false reversal sessions within the larger trend. So like other indicators, you need confirmation. Reversal days may also serve as confirming signals of other reversal signs. By themselves, reversal days are not as strong. In fact, by definition they occur after reversal is done, at times with a gap and an exceptionally strong price movement. So replying on reversal days alone means you miss the best time to make your move.
5. Independent confirmation. The most crucial aspect of spotting reversals is with independent confirmation. The previous four indicators are key elements. You need to see at least two of them at the same time, preferably three to be confident about timing your entry or exit. Additionally, seek strong single-session candlestick indicators to time reversal decisions. These include the hammer or hanging man, the long candlestick or marubozu, and the spinning top. These all work to confirm the traditional Western technical signals. Of course, also be aware of these: pay attention to increasing volatility near resistance or support, and the price action following well-known patterns that test the trading range borders.
No single session movement or pattern can be relied upon to improve timing or to spot reversals. This is why the concept of independent confirmation is so important, and why you need to track several different indicators at the same time. You want to see at least two separate patterns before deciding that a reversal is on the horizon. The combined Western technical indicators and Eastern indicators (candlesticks) expand your analytical toolbox substantially.
In addition, by combining Western and Eastern indicators, you are able to expand the "observation universe" of chart analysis. One criticism of charting as a means for timing of trading decisions is that there are too many variables and short-term prices are random and chaotic. That is partially true; but by adding in the element of confirmation, you overcome enough of the chaos to take your odds of great timing up to a new level.
About the Author
Michael C. Thomsett is author of Getting Started in Options,
Trading with Candlesticks
and numerous other books on technical analysis, stock trading and options.