What is a Reversal?
Reversal is a technical term used for change in the price direction of an asset. It can occur to the upside or downside. Reversal is also used by the technical analysts to reflect the onset of an opposite trend in an ongoing trend. It may be compared with breakouts. Following a downtrend, a reversal would be to the upside and following an uptrend, a reversal would be to the downside. It is not based on one or two bars/periods on a chart but on the overall price direction.
The stock generally shows reversal signs which may be technical indicator or price patterns such as moving average, Head& Shoulder, oscillator or channel, which may help in isolating trends and spotting reversals. Investor gets out of positions that are lined up with the tread before reversal or they will get out once they see the reversal underway.
What does a Reversal tell?
Reversal often occurs on various occasions in stock market during the same day and happens rather quickly, but they also occur over days, weeks, and years. It occurs on different time frames which are relevant for different investors for example a five-minute reversal doesn’t matter to long-term investors, but it can help day trader.
A downtrend is a series of lower highs and lower lows that reverses into an uptrend by changing to a series of higher and higher lows whereas an Uptrend is a series of higher swing highs and higher lows that reverses into a downtrend by changing to a series of lower highs and lower lows.
Treads and reversals can be spotted based on various indicators such as moving average and price action. In moving average if the price is above a rising moving average then the trend is upward and if prices drop lower the moving average then the trend is downward that indicates a potential price reversal.
An upward trend makes higher lows along which a trend line can be drawn and if the price decreases below the tread line, it may indicate trend reversal. If reversals are spotted easily it doesn’t mean trading would be easy as sometimes reversal happens so quickly and many false signal may occur that it become difficult for traders to act quickly enough to avoid a large loss.
Difference between a Reversal and a pullback
A reversal indicates trend change in the prices of an asset whereas a pullback is a short-term counter movement within an existing trend that doesn’t reverse the trend. Reversal or sometimes challenging to predict as it always start as potential pullback, the challenge is to spot whether it is only a pullback or a reversal.
An uptrend is created by higher swing highs and higher swing lows whereas pullback creates the higher lows. So, a reversal of uptrend doesn’t take place until the prices do not makes a lower low on the time frame the trader is watching. In case, investors or traders misidentify reversals for pullbacks and vice-versa that may face heavy losses and miss out potential profits, either by not pulling out at right time or by not sticking with a good thing.
Limitations of using reversals
Reversals are the important financial term in financial markets as prices reverse at some point and will have multiple upside and downside reversals overtime. If investors consider reversals, then they may face more risk than anticipated.
As reversal always start as potential pullback it become difficult to know whether it is a reversal or pullback and once it is confirmed that it is reversal, the price may have already moved, resulting in huge loss or profit erosion for the trader. Because of this trend investors or traders often exit while the price is still moving in their direction so they don’t need to worry if the trend is pullback or reversal.
False indicators are also reality as it may also lead prices to immediately move in the prior trending direction again if reversal occurs using price action or indicator.