How to Spot a Reversal: Technical Analysis 101

BALTIMORE (Stockpickr) -- We've all heard it before: "The trend is your friend."

Yeah, right.

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.

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