Reversal

Reversal, or trend reversal, is a term used by technical analysts and traders in the stock market. Traders use the identification of patterns in the rise and fall of stock prices to predict whether the market or the price of a stock is generally going to trend up or down, which helps them determine when to buy or sell stocks to make a profit. A reversal is a change in direction of the general trend of a stock price, and is the opposite of a continuation, in which a change in the direction of a stock price is only temporary.

Reversal patterns are identified by technical analysts, who use charts to study price changes. The identification of a reversal involves watching the rise and fall of the price of a stock over the course of a period that could be a day to many years, depending on the type of trading. There are various types of reversal patterns that can be identified and acted upon by traders.

Background

Identifying reversal patterns is a strategy used in technical analysis of the stock market. The price of a stock, or share in the ownership of a company, moves up or down according to the demand for that particular stock, which is based on its perceived value by investors. Investors can make money from owning a stock through dividends distributed by the company when it makes a profit. Investors can also make profits through the stock market by selling stocks at a higher price than that at which they bought them.

Anything can affect the price of a stock, including economic, political, social, or psychological factors as well as events in the news. Investors and professional stock traders usually rely on experts whom they hire to advise them on when to buy or sell stocks. One type of expert they consult is a technical analyst. The fundamental principle behind technical analysis is that the price of a stock reflects all information relevant to a stock price, as the reactions of traders to these factors in price are inherently reflected in charts that trace the movements in stock prices.

Technical analysts watch stock price charts on the basic premise that prices move in trends. This idea originates in the Dow Theory, an approach to trading developed by Charles H. Dow, creator of the Dow Jones Industrial Average and co-founder of Dow Jones & Company, Inc. The goal of technical analysis is to identify general trends in the upward and downward movement of stock prices. These upward and downward movements occur in zigzag patterns rather than straight lines as investors react to price increases and drops. According to the principles of technical analysis, the behavior of investors repeats itself over a period, and this behavior creates price patterns in the chart that can be studied to predict future price trends. The charts that technical analysts study are of three types: bar charts, line charts, and candlestick charts.

An “uptrend” is identified when the movement of the price, or “price action,” creates higher successive peaks and lower successive bottoms. The trend is a “downtrend” when the opposite occurs, with lower successive peaks and lower successive bottoms. When the peaks and troughs are roughly at the same level, or moving sideways, the trend is “in range.” When an upward trend changes direction to a downward trend, or vice versa, this is called a reversal, or reversal trend.

Overview

Technical analysts use the identification of reversals as a strategy for timing the buying or selling of stocks for the best chance of generating a profit. This is called “reversal pattern trading.” These analysts study the chart patterns to look for signals, or reversal patterns, which predict reversals. Both reversals and continuations, the opposite of reversals, are signaled as impending by the breaking of an important trend line. How substantial an upcoming reversal is likely to be is indicated by how long a pattern takes to complete, as well as the magnitude of the price fluctuations.

When analysts spot a reversal pattern in a chart, they will try to pin down an optimal time to either buy or sell a stock to make the most profit. This point is called a “price target.” There are two main types of reversal patterns. A bullish reversal pattern is an indication that the price trend will change direction from a prior downward trend to an upward trend. Technical analysts spot a bullish reversal pattern in the stock price charts by looking for a “double bottom” shape, which looks like the letter W. This pattern is an indication that sellers of stock are failing to gain control in a battle between buyers and sellers. When more buyers enter the market than sellers, this pushes stock prices higher. When this pattern is spotted, traders will attempt to buy at the price target. The opposite of a double bottom is a “double top,” which looks like an M, which predicts that an upward trend is going to change direction to a downward trend, in which case traders will try to sell at the price target.

Another significant reversal pattern is called a “spike reversal” pattern or “V-reversal” pattern, as it takes the shape of the letter V. Such patterns can occur with a sharp previous upward or downward trend. In this case, prices have reversed direction without any previous signals. This is also referred to as the market “turning on a dime.” Traders consider spike pattern reversals to be a difficult time to trade and, therefore, avoid the market.

The tendencies in the market that technical analysts use to predict reversals through reversal patterns can be significantly affected by big economic and news events. Such external catalysts can cause uncommon movements, such as big trends, reversals, or movements during times when there are usually no significant movements, such as during the lunch hour. For example, Standard & Poor’s downgrading the sovereign rating—a country’s credit rating for borrowing money—for the United States on August 5, 2011, caused the S&P 500 to react with a downward reversal. Reversals can also occur for single stocks over the long term. One example is that of Apple. Between 1986 and 2000, stock in Apple dropped dramatically as it lost its market share in the PC market from 16 percent to 2.7 percent, and its share price followed to hit a low of $6.56. After Apple shifted its focus to the MP3 market, its market share rose to 72.7 percent, and by June 2014, its share price rose to $700. This reversal was one of the biggest in a decade. Another example is Elon Musk's Tesla stock. The stock price experienced a significant trend reversal in early 2023 after ruling the technology sector for several years. Rising interest rates, increased competition, and supply chain issues were cited as the source of the reversal. However, by the end of the year, the company's stock was back on track.

Bibliography

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