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How to Spot a Reversal: Technical Analysis 101

How to Identify a Reversal Early

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.

The chart above of the S&P during 2008 is a perfect example of that. By relying on the long-term trend lines rather than gut feelings, you would have been out of the market early and back in early.

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 some experience.

Must Read: Why Trend Line Support Matters

Momentum oscillators are another tool that can help you spot reversals. Oscillators are technical indicators that are banded between two extreme numbers or have a base value. These momentum gauges 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. 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.

Keep in mind that a red flag from a technical indicator isn't an automatic sell signal. Only buy or sell on a meaningful price move.

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