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Spotting a Reversal: Technical Analysis Primer

As with most technical tools, trend lines aren't set in stone. They're subject to adjustment as a stock's price action works itself out. So a trend line break in a bull market may not in and of itself signal the start of a major secular downtrend. That said, more often than not, trend line breaks signal intermediate reversals at the very least. These can be played profitably with more than a little experience.

Oscillators are another tool that are used frequently to help spot reversals. Oscillators are indicators that are banded between two extreme numbers or have a base value. Typically, they are momentum indicators, and can signal overbought or oversold conditions when they're at extremes. Common oscillators include RSI, MACD and stochastics. Don't be fooled into common practice with oscillators -- while a move to oversold or overbought territory does indicate a reversal could be forthcoming, it's actually quite common for stocks to keep running as momentum continues to accelerate.

Instead, use oscillators alongside other indicators for the best chances of spotting a reversal. Watching out for a negative divergence between share price and RSI, or a bearish crossover in the MACD, for example, are two indicators that the market is topping.

Economic data can also be a good indicator (contrarian or otherwise) of a top or bottom in the stock market. Remember, the crowd is typically wrong; high levels of pessimism or optimism generally indicate that the market is headed for a reversal to the other direction. When looking at sentiment data alongside prices, it's crucial to look at enough data to get a glimpse of where sentiment has historically stood through several previous market cycles -- otherwise, you may not have a full picture of which sentiment numbers are significant.

Increasing Profitability on Reversal Bets

Because spotting reversals isn't foolproof, it's important to use smart risk management techniques to avoid getting hammered if a potential reversal fails. The easiest way to do this is with well-placed stop losses (hard or otherwise) just inside the stock's trend line. Don't ever try to "top tick" a reversal by betting against stocks while they're still in uptrend mode -- waiting for the reversal to actually occur, then capturing the meat of the move, is a significantly more profitable strategy.

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