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By: Chris Rowe — July 31, 2012

Technical Tuesday - Beware of Today's Bearish Reversal Pattern!

If you understand what a reversal day looks like, trading can be simple!

Some people email me asking how I "knew" the market was about to reverse.  I've been getting emails like that for well over a decade (don't forget when most people really started using email!).

I never know for sure, but as students of my Technical Analysis Millionaire program understand, there are obvious clues that can steer you in the right direction most of the time. 

When my students first learn about these clues they are often very skeptical.  "How can it be this easy?  If it were this easy, everyone would be making money in the financial markets."

Wrong.  Someone always has to lose in the financial markets.  The fact is, it's peoples' emotions that are the main cause of wealth destruction.  And very few people can escape that.  But for those who can, trading can be easy.

What I'm going to show you can be applied to virtually every financial market:

  • The Bond Market
  • The Currency Market
  • The Commodity Market
  • The Stock Market

The reason you can apply the methodology to virtually every market is that charts are merely a historical record -- a picture -- of human emotion. 

Below I've circled periods of indecision.  There are many different styles of charts you can use to identify them, but Candlestick Charts are the best (in my view). 

Notice that I circled yesterday's activity.  This means it's likely, but not certain, that the trend will change.  It typically reverses in the opposite direction.  In this case, down.  But sometimes it's the precursor to a consolidation period (when prices seem to move sideways before resuming their prior trend).

It appears the U.S. stock market wants to reverse lower here.  Or perhaps just consolidate.  But it's always best to lean toward the assumption that the market will do what it's most recently been doing.  In this case, it's been zig-zagging up and down in an upward channel. 

I used this upward channel (not marked on the chart today) to identify periods when the short-term bullish reversal was likely.  In fact, the articles were written before the reversal days had even shown themselves...

  1. I wrote "Be Bullish Here.  Period."
  2. I wrote "Bearish Reversal, or Bullish Godsend?"

But let's talk about what the reversal day (or week) actually is.

Take another look at the chart above.  Every day that I circled has something in common.  They have small "bodies".  Known as "real bodies", these thick filled-in parts of the candles show the difference between the opening price and the closing price. 

The thin parts that look like the wick of a candle, known as "upper and lower shadows", show the rest of the trading range for that day -- the highest and lowest point the stock or index reached. 

For example, the S&P 500 opened at 1,385.94 and closed at 1,385.30.  So the difference between the opening price and closing price was only 0.64.  It closed at nearly the same price that it opened.  Therefore, the red thick part (the "real body") is very small. 

This implies a period of indecision, and periods of indecision are often signs of a reversal.  The trend is obviously not strong.  Neither the bulls nor the bears are confident enough in their decision to push prices much of anywhere. 

But notice the upper and lower shadows (the wicks).  The day's trading range was actually very wide.  The high was 1,391.74 and the low was 1,381.37.  So compared to the 0.64 point difference between the opening and closing price, the day's trading range was over 10 full points.

Here are a few rules to take away from this article:

  1. Periods of indecision can be applied to daily charts or weekly charts.  Although less reliable due to the fact they are much shorter term in nature, they can be applied to intraday charts as well.
     
  2. Reversal days should be confirmed.  Some traders are very aggressive and are willing to take positions before seeing confirmation.  Those traders are prone to more false signals, which they accept in return for getting in and out of positions earlier than those who wait for confirmation. 

    I prefer to wait for confirmation.  Confirmation is when, the following day (or time period), the market does in fact move in the opposite direction as the recent trend.  The very conservative traders might wait to see where the market would close on that confirmation day, and the traders who were conservative enough to wait for the second day but less conservative than the trader I just mentioned might take their position in the early part of the day.

    If you study the chart above, you'll find times when the trader was rewarded for waiting for confirmation and other times when the trader would have been much better off by entering her position in the early part of the confirmation day.  
     

  3. There must be a trend in place to reverse!  The bigger the prior trend was, the more potent the reversal pattern would be.  For example, look above at where I circled a whole bunch of candles.  All of them have small real bodies.  But they weren't exactly found after a strong trend.  They were found after one big day higher, which was a rebound off of a major low. 

    There was no confirmation of the reversal.  And I would have taken note of the small bodies as a sign that the new up trend may not have been that strong.  I mean, I would be prepared for a reversal.  But I gave those real bodies a lot less respect as potential reversal days since they didn't appear after a real up trend. 

    As you can see, there was one more big jump higher, which was followed by another kind of bearish reversal pattern that we don't need to go into today. 
     

  4. Finally, there are many other signals or clues that you can find when studying a chart.  I wrote an article two weeks ago titled "Where The Smartest Traders Will Sell Stock".  In it, I discussed a major down trend line that will probably be reached and will probably act as a difficult resistance level.  It's not marked on the chart, but you can go read the article to see what I mean.  The point is, that down trend line is being touched right now while we are seeing a potential bearish reversal pattern unfold. 

So that's pretty much it.  I know it sounds so simple, and hopefully that sheds some light on why you may feel like some traders seem to make it look so easy.  It's because it often is. 

The difficult part is stripping out your emotions.  I'd venture to say it's not even possible to do so.  But you can make it a life long practice to work on reducing the emotional aspect of trading.  And the first step to doing that is to learn about the simplest and most obviously technical patterns and play them.

Until next Tuesday!

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