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Spotting a Reversal: Technical Analysis Primer

BALTIMORE (Stockpickr) -- If you've been exposed to the main ideas behind technical analysis, you already know that trend is one of the cornerstones of technical trading. Studies have shown that prices move in trends -- and that following those trends is one of the most effective ways to significantly grow your portfolio.

But trends ultimately fail, leaving latecomers holding the bag for those who were prescient (or lucky) enough to get out early. The key to being one of the latter is to spot reversals early.

Of course, as with most stock trading tactics, spotting reversals is much easier said than done. Today, we'll take a look at some tools that can help you spot reversals early and spare your portfolio from losses.

Related: Must-See Charts: Baidu, Wal-Mart, PetroChina

The Challenges of Spotting a Reversal

Simply put, a reversal occurs when a stock changes trend and starts to move in the opposite direction of previous price action. Psychologically, reversals can incredibly difficult for even the most experienced investors to react to. That's because in the early stages of a reversal, the market's still showing many indications of a continued move in the original direction.

The market meltdown of 2008 was a good example of a powerful downtrend that was difficult to spot the end of. While the lows of March 2009 are easy to spot with the benefit of hindsight, it was considerably more difficult to go long stocks in 2009 after the market had already punished bulls so fiercely in the preceding year.

But by the time skittish mainstream investors had piled onto the stock-buying game, a significant chunk of the market's initial move was already behind it. Improving reversal recognition is one remedy for that.

Naturally, markets aren't always trending -- quite often, markets can trade without a discernable direction. Spotting reversals in ranging markets is important too; not only can reversals tell you when a major trend may be about to begin, they also can be a shorter-term trading opportunity for more active traders.

Tools to Use in Identifying Reversals Ahead of Time

One of the most effective tools for spotting a reversal is also the most simple: the trend line. A trend line connects intermediate lows or highs of a stock -- in an uptrend, it connects lows (or troughs), while in a downtrend it connects peaks. If share prices punch through a trend line, the trend may well be broken.

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