BALTIMORE (Stockpickr) -- We've all heard it before: "The trend is your friend."
Trends fail. They break down. They're not infallible. And they can cost you money.
But it doesn't have to be a love-hate relationship. Typically, some telltale signs accompany weakening price trends, and by catching them early you can squash your risks -- and even make money when the price action reverses course.
If you've been exposed to the main ideas behind technical analysis, you already know that trends are one of the cornerstones of technical trading. They're an important part of the technical toolbox because, more often than not, they work. Studies have shown that prices move in persistent trends -- and that following those trends is one of the most effective ways to significantly grow your portfolio. But all trends eventually fail, leaving latecomers holding the bag for those who were prescient (or lucky) enough to get out early.
The key is to be on the lookout for those reversals.
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.
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 be incredibly difficult for even the most experienced investors to react to. That's because in the early stages of a reversal, the market still shows 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.
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 discernible direction. Spotting reversals in ranging markets is important too; not only can reversals tell you when a major trend may be about to begin, but they also can be a shorter-term trading opportunity for more active traders.
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.
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.
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 outside the stock's trend line.
In especially volatile markets, reducing your position sizing is another excellent way to reduce your risk exposure and limit the amount of drawdown you see while you're looking for trend reversals.
Don't ever try to "top tick" a reversal by betting against stocks while they're still in uptrend mode. A breakdown in price should always be your trade signal. Instead, wait for the reversal to actually occur, then capture the meat of the move. While being reactionary will cost you a few points on either side of the trade, it'll dramatically increase your success rate.
While spotting reversals early can significantly improve your ability to profit in both bull and bear markets, it's likely one of the most difficult (and sought-after) skills to master in technical analysis. As with most disciplines, practice is key.