Reversal Bars Signal Trend Change

02/02/10 09:49:56 AM

by Alan R. Northam

Many methods can be used to determine the trend of the market. One such method is the use of one- and two-bar reversal patterns.

Security: !DJ30
Position: N/A

Many methods can be used to determine the trend of a market. Most of these methods involve using moving averages or momentum indicators, both of which introduce a lag in determining the trend of a market and are therefore lagging indicators. Normally, lagging indicators are used to confirm a trend but are a poor selection when trying to identify a trend reversal. One method that can be used quite successfully is the one- and two-bar reversal patterns.

When trying to identify long-term trend reversals using one- and two-bar reversal patterns, the monthly bar chart is used. Figure 1 shows a two-day reversal bar pattern that identified the 2007 market top as well as the one-day reversal bar pattern that identified the 2009 market bottom. The 2007 market top was identified by a two-bar reversal pattern known as a pivot point reversal. A pivot point reversal is formed when a market such as the Dow Jones Industrial Average (DJIA) forms a high bar followed by a second bar with a closing price below the low of the highest bar. Pivot point reversal patterns are the most common of the one- and two-day reversal patterns. Being the most common of the reversal patterns, they are the ones that normally fail as a reversal signal. Therefore, it is best to look for some confirmation before determining that a trend has changed. The most common method is to look for two following consecutive bars with lower closing prices: On the chart these are normally numbers 1 and 2.

FIGURE 1: DJIA, MONTHLY. The bar chart shows one- and two-bar reversal patterns.

Graphic provided by: AmiBroker.com.

The market reversal in early 2009 was identified by a single closing price reversal bar. Closing price reversal bars are formed when a bar opens below the low of the previous bar and closes in the top half of the bar and above the close of the previous bar. Closing price reversal bars are very reliable reversal signals, and the closer to the high of the bar the market closes, the stronger the signal. Thus, the closing price reversal bar made in March 2009 was a fairly strong reversal signal. Each bar following the closing price reversal bar that each bar made, a higher one indicating the strength of the trend following the strong reversal bar was made.

This brings us to January 2010, when a key reversal bar was made. A key reversal bar occurs when a market opens above the closing price of the previous bar and closes below the low of the previous bar. Key reversal bars do not occur very often but when they do, they are very reliable. Therefore, the key reversal bar that has formed on the monthly chart of the DJIA in Figure 1 is a very reliable signal that the long-term trend of the market has reversed from up to down.

Long-term trends normally last for a year or longer. Therefore, the key reversal signal that formed in January 2010 is a strong indication that the long-term trend has now reversed downward and should last for at least a year. As a confirmation, the next two months should produce bars with consecutively lower closing prices.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.