Choosing the price where a stock is going to change directions has been the subject at the forefront of every trader's mind pretty much since the dawn of free-market trading. Every trader wants to buy at the very bottom and sell at the very top. Unfortunately, this scenario rarely occurs in a trader's career, much less every time they trade.
However, there are some tools and techniques you can use to anticipate better when a stock is about to reverse. Armed with that knowledge, you can better adjust your stops, take your profits, and realize more and larger trade gains. We call these signals early reversal signals as they are the things which happen just before a trade is to reverse.
In and of themselves, these signals are not enough reason to switch your position and trade the opposite way; however, with these three tips, you can get a head start on identifying reversals and be ready to make the money when the opportunity is presents itself.
The stochastics oscillator is designed to show overbought and oversold levels. If you are getting into a solid bullish trend, the oscillator may show overbought, and it may stay there for a while, but where this indicator shines is identifying when a swing is over in a sideways moving channel.
When a trend has traded very high and is ready to roll over, the stochastics indicator will typically cross down from above its overbought readings. If you see this happening, it's time, at the very least, to tighten your stops, but it's probably time to close the trade and take any profit you have off the table. The reason is that a bearish follow-through could be swift and costly.
The second scenario where the stochastics is very good at helping identify a reversal before it happens is when you have a stock that is trading in a channel.
In a channel, the stock is somewhat stuck bouncing between support and resistance in a trading range. Look at this example of AAPL stuck for several months between $120 and $130.
During these market conditions, the stochastics is an excellent tool. Look at the example below and notice how frequently the stochastics indicator gets to overbought when the stock is approaching resistance, and oversold when the stock is approaching support.
These signals are great because they typically tell us within just a couple of trading days that the stock is ready to swing the other way, and that creates a great opportunity to either flip your position or at the very least, an opportunity to lock in your profits from the previous trade.
The stochastics oscillator can be a great early reversal warning.
One of the oldest techniques in predicting a reversal, and still one of the most proven and time tested, is the technique of identifying resistance zones. This technique is documented to be at least 100 years old. Regardless of how old it is, it still works as well today as it did in the early 1900s.
Identifying resistance is as simple as looking to the left on the chart and drawing a line at every price point where a stock made a major turn. It seems simple enough, but the miracle is this - when the stock gets back to this price range, more often than not it will stop trading and will reverse.
Notice in the above picture that the resistance we drew just below $55 served as a support later. The resistance at $65 certainly represented indecision, and the ultimate resistance on this chart was, in fact, the same resistance we found around $74 more than a year before.
Stocks tend to trade to pivot points over and over, and if you will take the time to learn to draw and identify your major resistance points, you'll be amazed at how much earlier you can identify a stock is about to reverse.
Stochastics are great, and recognizing where resistance will be is essential, but if you want to have the earliest signals that a stock is about to reverse, you must learn to interpret your candlesticks patterns. Candlestick patterns are one of the only tools we have that offers a direct interpretation of the day to day sentiment that is evolving on a trade. Sometimes the patterns do not play out, but more often than not, the reversal patterns, if they occur at a resistance level, do a very good job anticipating and predicting when a swing has hit its limits.
Take a look at pretty much any stock, and at almost every one of its major turning points, there will be a candlestick reversal pattern to support it. This recent chart of SPY illustrates this perfectly. Notice that literally, every turning point since September has included one of these powerful candlestick reversal signals.
There are a lot of candlestick patterns, but there are only a handful that are extremely useful as a reversal signal.
These are the most powerful reversal signals you will see, and they occur early in the reversal, usually at the very high point of the swing. The following are additional reversal signals that are not as strong, but often become part of a cluster that leads to a reversal:
While this list of patterns may seem overwhelming, there are only about 11 variations of candlestick patterns that you need to learn - that's not very many. However, the benefit of taking the time to learn them can pay huge dividends. At least one of these candlestick reversal signals occurs at probably 90% or more of the market swings. That means, if you learn to identify them, you will have the upper edge against your competitors in the market.
Armed with these early reversal warnings, you can adjust your stops to lock in your profits sooner. This will help you keep more of your hard-earned trade profits. Moreover - when you recognize these turning signals, you will have an edge to get into the trade sooner.
When you pair all 3 of these early reversal signals together, it can create a very high probability of the reversal, and that means more opportunities for you to get in early and capture the profits.
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