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Trader's Corner

'Key' Reversals

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My Trader's Corner topic today was a result of looking at the charts for recent examples of any so-called 'key' reversals, prompted by an e-mail from an Option Investor Newsletter (OIN) subscriber. Given the recent twists and turns of the market, it was not surprising to see examples of both 'common' upside or downside reversals and that of a 'key' reversal.

Can you cit any recent index examples of what you call in your (Essential Technical Analysis) book key reversals? Also, how do you see the market currently. building a top or consolidating?

Regarding "upside key reversals" and the last 6 words in the parentheses at the bottom of page 151: "(a 2-day key reversal down)". Should this not read "(a 2-day key reversal up)"? Please also advise if there are other corrections, additions, etc. that would be useful for me to know.

Before I launch into answers on the first part, a note on the book error you cite. I 'flagged' that error some years ago to my published (John Wiley & Sons) and it would normally have been corrected in later printings of the book but am unsure it was. Now the book is still pretty widely available, but out of print.

I made the error of writing 'down' instead of 'up' (bottom, page 151) and didn't notice it in my subsequent editing before the book was printed. You are completely correct in knowing that 'down' should have been 'up'.

A most common error in trading is to say or write 'buy' instead of 'sell' or vice versa. This error was of that sort. However, there are no other errors of this type in the book, nothing certainly where a definitional term or description is wrong. I use the book myself as a reference and know how important it is to have all elements of technical analysis correctly described.

So far, the recent sideways move, as seen below on the hourly charts, has the appearance of a consolidation, ahead of another attempt to move higher, perhaps to challenge the highs to date.

Interestingly, the first index to 'break out' above the recent consolidation pattern was the Dow 30 Industrials (INDU). Now that tech has 'cooled' off some, the old institutional favorites are back in play more than in recent weeks.

The recent sideways move can be seen as a bullish consolidation (of the current up trend) provided prices don't retrace much more than the lows seen after a PAUSE in the sharp advance. The lower 'line' of hourly lows becomes the low end of a pattern called a 'flag' pattern, which often, not necessarily in all instances, occurs after a steep rise suggesting a narrow 'flagpole':

In a flag type pattern, prices consolidate in a relatively narrow trading range between the approximate same highs and lows for 2 to 3, maybe 4 days, but not much longer. If this pattern is truly a consolidation of the bull 'flag' variety, prices soon pierce the recent highs or the upper end of the flag as seen above.

Looking at the actively traded Nasdaq 100 (NDX) Index hourly chart below, a similar type consolidation as INDU has taken place only absent the upside breakout, so far at least. When you see this type pattern with the low end of a consolidation holding likely support as suggested by prior highs, a gap, etc., assume that this index is going higher. [UNLESS of course, prices fall and stay below the low end of the recent trading range.]

Today's NDX close was just above the hourly down trendline and it looks like the next move is to above the high end of its recent trading range, then probably on to re-test the prior highs. [The cautionary note is that a fall below 1605-1600 support especially on an hourly, then daily, Closing basis would be bearish.]

NDX's recent back and forth price swings above have the appearance of a consolidation within an uptrend. 'Consolidation' has the technical meaning of: movement WITHIN THE EXISTING TREND; as opposed to a 'reversal' pattern such as a Head & Shoulder's, Rounding, or Double Top/Bottom pattern.

Currently, the short, intermediate and long-term trends are up in the major indexes with the exception of the S&P 100 and Dow 30, which have not 'confirmed' their being in a longer-term uptrend.

Upside and downside reversal patterns are most often talked about on daily charts and will be below, but the same principles apply on intraday (e.g., 60-minue) or weekly charts.

A strong sign of a trend reversal and which is often the start of an intermediate or long-term trend change, is the formation of a 1 or 2-day KEY reversal. Often you'll hear that a key reversal is a new Low or new High, relative to the prior 1-2 bars (e.g., prior hour, day or week), followed by a Close that is respectively above or below the prior day's Close.

In my book I say that a downside KEY Reversal day is a day where there is a higher High than the prior day AND the CLOSE is below the prior days LOW (a downside key reversal); or the close is below the prior 2-days' Low (a 2-day downside key reversal).

Under this more restrictive definition, an upside KEY Reversal is the reverse of the Downside key reversal: a lower Low than the prior 1-2 days, followed by a Close above the HIGH Of the prior 1-2 days. There are less of these kind of reversals and, in my experience, are more predictive for trend reversals of a longer duration.

The S&P 500 (SPX) Index's daily chart is show below. As it happens, there is a 2-day Key Downside Reversal that occurs, followed a few days later by a 2-day Key Upside Reversal. It's somewhat unusual to see key reversals back to back, but not so surprising after a 100-point advance from October. Since the Key Upside Reversal pattern is going WITH the dominant trend, it is given greater weight in suggesting a move to new highs, which is what occurred of course.

The sharp downside move outlined in grey in the SPX daily chart above, would have been a Key Downside Reversal if the High had been above the prior day's High. This day forms neither a 'common' or 'key' downside reversal pattern. [If there had been a High above the prior day, a Close under the prior 1-2 day's Close would have formed a Downside Reversal, a Close below the prior 1-2 day's LOW, would have formed a KEY Downside Reversal.]

Key Upside or Downside Reversals have the same basic criteria as what Jack Schwager calls a Bull Trap (downside) or Bear Trap (upside) reversal: there's a new Low or new High for a move, followed by an immediate SUBSTANTIAL counter-trend/reversal type move. I simply define what 'substantial' is; i.e., a Close that is greater than the prior day's High or Low.

Note the relative importance of the new High/new Low criteria. In the SPX (chart above): the recent 1-day fall, although sharp, was also short-lived. That day was lacking a higher High than the previous day. A subtle difference, but price patterns often have subtle elements that tell us the difference between a correction to the trend (still WITHIN the trend) and a (trend) REVERSAL.

This Wed. Trader's Corner article serves as an adjunct to my weekend Index Trader (IT) column, where I can both update a technical picture of the market as of midweek, using it as a means to discuss, and more fully explain, relevant chart pattern types and technical indicators. The IT is only available on the Option Investor (OI) web site, as it's not included in the e-mailed weekend OI Newsletter.

You will see a LINK to the Index Trader at the top of your weekend e-mail. My most recent (Sat, 1/28) Index Trader can be viewed/reviewed by clicking here.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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