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One-Day Reversals

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While dozing at my desk today, my Option Investor Newsletter (OIN) inbox alarm bell rang and I was abruptly jarred awake by the following OIN Subscriber e-mail QUESTION: "Would today's price action constitute a 1 day or key reversal as you discussed from time to time?"

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RESPONSE:
No, and I thought I would riff on what constitutes a One-Day Reversal (ODR); this pattern being important for the following reason: When a top and reversal is made at a prior high or at other such possible congestion, it's relatively easy to point to a possible top and the day that it happens doesn't necessarily come from an upward "spike" followed by a close near the day's low.

In the recent market run up I've been thinking that a re-test of the prior highs, which are not all that far away in the lead S&P 500 (SPX), is a likely outcome for the recent rally dating (initially) from a month ago. Relative to yesterday's SPX intraday peak around 1449, the prior high for the multimonth advance is at 1461.5, made on February 22nd and is not all that distant.

The general definition of a One-Day Reversal (acronym: ODR) down that suggests a TOP: A large 1-day upward price spike, followed by the price of the index or stock closing near the low of that day. A one-week reversal down is the same but price action is measured on a weekly time frame. The reversal or price consolidation that is suggested in a ODR is a short (up to 3 weeks) to intermediate-term (up to 3 months) bearish reversal.

Under this definition NONE of the major indexes had a rally to a substantial new high for the recent advance; no intraday high was made that was above yesterday's peak price for the day and by definition here a 'spike' is a move up to decisive new high (or down to decisive new low). I will show charts where there were One-Day Reversals (ODRs) down and ODR up and what happened as far as this type chart action 'signaling' a sustained (3 weeks to 3 months) reversal in the trend afterwards.

What we had today was an apparent short-term rally failure in that prices retreated well under the prior two days' low and made a new 5-day low Close. What IS significant to me concerning a possible trend change is not a 1-day reversal down pattern (that didn't happen), but the reversal from the prior downside GAP area in the Nasdaq index charts. I'll today also go into a possible rally failure from the area of resistance implied by the high end of chart 'gap' in the case of the Nasdaq Composite (COMP) and the pullback that happened after the Nas 100 (NDX) chart gap was 'filled in'.

Going back to One-Day Reversals: There is something called a chart pattern 'failure'. In the case of the ODR down it's where the formation of the pattern does NOT result in a sustained trend reversal thereafter. The so-called failure rate of the ODR down chart pattern according to one study is only around 24%; that is, only about 24 percent of the time is there NO trend reversal that follows AFTER a ODR down. The average decline following such a downside reversal in STOCKS is 10-19%. There tends to be heavy volume on the reversal day, but volume thereafter recedes quickly. There are rebounds about 70% of the time BACK to the price area where the reversal took place, followed by a second wave of selling and a price decline. I'll talk about the One-Day Reversal UP further on, after a look at some charts.

I did not outline today's price action in my first chart; today's action is easy to see as the last bar on the SPX daily chart below. There was of course no 'spike' up to a substantial new high followed by a close near the low; rather, there was only a close near the low. Today's price/chart action did fulfill the definition of a 1-day reversal pattern.

I've outlined TWO similar earlier 1-day patterns in yellow (#'s 1 + 2) that were much more extreme in how far down SPX went on those days. But in each case (back in November and in February), there was an immediate rebound (#1 example) or at least only a short-lived trend reversal in example #2 although that day saw a very steep decline. It is what the pattern suggests about the subsequent TREND that is what I am keying in on here.

Example #3 was a One-Day Reversal (ODR) UP as, in this example in March, the ODR up criteria was fulfilled; i.e., a large 1-day downward price 'spike' with prices then closing near the HIGH (VERY near on this day). The percentage gain from this day's low at 1364, up to yesterday's high around 1449, equals a 6 percent rise to date. A pretty healthy run up so far after the ODR up back on March 14th.

I gave figures above for STOCKS of an average DECLINE of 10-19 percent AFTER a ODR Down. For a One-Day Reversal UP, it's not quite as much, with the most likely rise in the STOCKS studied by Thomas Bulkowski being between 10 and 15%. Moreover, the amount of decline or amount of rise is not as much in the INDEXES as in STOCKS after either a One-Day upside or downside Reversal. I haven't done a study on this, but as you know, a 10% rise for example in SPX is a far more significant thing than a 10% rise in a stock trading at 30 or 40 dollars.

TThe pattern vis a vis the S&P 100 as to either a ODR Down (none) or a ODR Up (one) for the period shown above with SPX, is the same in the S&P 100 (OEX) with the rise from the low of March 14th when a ODR up occurred, to yesterday's high, also around 6 percent.

I have to go back a long ways to find an example of a ODR Down in the S&P and Dow Indexes, but want to stay more current. Since ODRs Up AND ODRs Down in stocks are more common, I'll take an example of a 1-day downside reversal or actually two of them, for Google (GOOG); the daily chart of which is seen next below:

Not only was the January top a 'double top', relative to the November high, but the pattern on the second top's price action (on 1/16) also constituted a ODR Down; i.e., there was a spike up to a substantial new high, then beaten back by selling which caused GOOG to close the day near its low. A couple of weeks later a rebound carried back up to the price area where the ODR occurred. I mentioned already that such rebounds back to the area where the reversal occurred is pretty common, about 70 percent of the time in one study of such patterns in stocks. It is so common in fact that it suggests that in terms of buying PUTS on the stock, it might be advisable to WAIT for such a rebound to occur.

A second 1-day downside reversal occurred this year in GOOG and the rebound over several weeks after that has carried the stock back to the area of that second ODR down; and, to date at least, prices have backed off from THIS area. Stay tuned on whether this continues!

GAP AREAS THAT SUGGEST RESISTANCE (OR SUPPORT)

I mentioned in my recent Index Trader column about Nasdaq, resistance and perhaps a capping of the recent rally could occur in the downside price gap area that was made a back in late February when prices fell from one day to the next such that the high that following day was well under the low of the preceding day; creating a price 'gap' on the chart. Such overhead gap areas often act as later resistance where there could be substantial selling interest. First, something about the same ORR Up seen on the Nasdaq 100 (NDX) chart about a month ago.

The day highlighted as #1 on the NDX daily chart below appeared to be an upside reversal, at least no LOWER low was seen after that day. However, a reversal of the TREND (back to the upside) did not really get underway until there was NOT ONLY a spike low, but where prices then also closed near the day's high; in example #2 this was right AT the day's high. After this ODR up, the rise has been substantial.

As for the resistance question relating to an overhead chart gap: There is an old saying about how 'gaps get filled in'. There is more to this old saw, in that gaps tend to get filled in followed by prices (the trend) then reversing. A more simple way to say it, per John Murphy, is that gap areas ABOVE current prices tend to act as resistance and gaps BELOW current prices tend to act as support.

Recent price action in Nasdaq, with a number of key tech stocks pulling back after NDX's gap was precisely filled in, raises the question of the staying power of this recent rally, even though there are no other signs of a reversal such as of the One-Day variety I've been discussing.

There was the beginnings of an 'overbought' condition seen in the S&P (first chart), but overbought/oversold is not a conclusive indicator that a trend reversal is or will be occurring. However we don't probably have long to wait as we stay tuned to what's next on the Street of Dreams!

GOOD TRADING SUCCESS!
 

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