DEFINITION of 'Reversal'
A reversal is a change in the direction of a price trend, which can be a positive or negative change against the prevailing trend. On a price chart, reversals undergo a recognizable change in the price structure. A reversal is also referred to as a "trend reversal," a "rally" or a "correction."
BREAKING DOWN 'Reversal'An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows. A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.
Reversals often occur in intraday trading and happen rather quickly, but they can also occur over days or weeks of trading. Technical analysts watch for reversal patterns throughout the day, because they can indicate the need for a different trading strategy on the same security or can provide an opportunity to profit. Intraday reversals are often the result of news events and company announcements that change the valuation outlook for a specific stock.
Potential Trading Strategies
By watching the technical charting of a stock’s price, traders can identify when a reversal is occurring. Traders often anticipate a reversal to occur in a stock that has been consecutively reaching new highs or new lows. In technical trading analysis, traders often closely watch the candlestick movements of a stock. In technical analysis, the candlestick represents the stock’s trading price range throughout the day, with the top being its highest price and the bottom being its lowest price. A candlestick chart shows the consecutive movement of the stock’s price throughout the day, with emphasis on its trading range.
Example of Trading Strategy
An example of a trading strategy for a stock reversal to the downside could occur when a technical analyst holds stock ABC and notices a reversal pattern in the candlestick charts. Technical analysts typically consider a reversal trading pattern reliable to trade upon after five to 10 consecutively lower candlestick patterns trading within approximately a five-minute timeframe. When this occurs, a trader seeking to profit on a reversal to the downside could close his existing long position and assume a short position, to capitalize on the downward movement of the stock's price.
Given the opposite trading scenario, a technical analyst seeking to profit from a reversal to the upside would initiate the opposite strategy. If the trader sees adequate consecutive candlestick pattern movement to the upside after the stock’s price has been trending downward, the trader may assume a reversal and could then enter into long positions to benefit from the rising prices, and close out short positions to stop the investment from incurring further losses.