Reversal Explained

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Market Reversals and How to Spot Them

Capturing trending movements in a stock or other type of asset can be lucrative. However, getting caught in a reversal is what most traders who pursue trendings stock fear. A reversal is anytime the trend direction of a stock or other type of asset changes. Being able to spot the potential of a reversal signals to a trader that they should consider exiting their trade when conditions no longer look favorable. Reversal signals can also be used to trigger new trades, since the reversal may cause a new trend to start.

In his book “The Logical Trader,” Mark Fisher discusses techniques for identifying potential market tops and bottoms. While Fisher’s techniques serve the same purpose as the head and shoulders or double top/bottom chart patterns discussed in Thomas Bulkowski’s seminal work “Encyclopedia of Chart Patterns,” Fisher’s methods provide signals sooner, giving investors an early warning of possible changes in the direction of the current trend.

One technique that Fisher discusses is called the “sushi roll.” While it has nothing to do with food, it was conceived over lunch where a number of traders were discussing market setups.

Key Takeaways

  • The “sushi roll” is a technical pattern that can be used as an early warning system to identify potential changes in the market direction of a stock.
  • When the sushi roll pattern emerges in a downtrend, it alerts traders to a potential opportunity to buy a short position, or get out of a short position.
  • When the sushi roll pattern emerges in an uptrend, it alerts traders to a potential opportunity to sell a long position, or buy a short position.
  • A test was conducted using the sushi roll reversal method versus a traditional buy-and-hold strategy in executing trades on the Nasdaq Composite during a 14-year period; sushi roll reversal method returns were 29.31%, while buy-and-hold only returned 10.66%.

Sushi Roll Reversal Pattern

Fisher defines the sushi roll reversal pattern as a period of 10 bars where the first five (inside bars) are confined within a narrow range of highs and lows and the second five (outside bars) engulf the first five with both a higher high and lower low. The pattern is similar to a bearish or bullish engulfing pattern, except that instead of a pattern of two single bars, it is composed of multiple bars.

When the sushi roll pattern appears in a downtrend, it warns of a possible trend reversal, showing a potential opportunity to buy or exit a short position. If the sushi roll pattern occurs during an uptrend, the trader could sell a long position or possibly enter a short position.

While Fisher discusses five- or 10-bar patterns, neither the number or the duration of bars is set in stone. The trick is to identify a pattern consisting of the number of both inside and outside bars that are the best fit, given the chosen stock or commodity, and using a time frame that matches the overall desired time in the trade.

The second trend reversal pattern that Fisher explains is recommended for the longer-term trader and is called the outside reversal week. It is similar to a sushi roll except that it uses daily data starting on a Monday and ending on a Friday. The pattern takes a total of 10 days and occurs when a five-day trading inside week is immediately followed by an outside or engulfing week with a higher high and lower low.

Testing the Sushi Roll Reversal

A test was conducted on the NASDAQ Composite Index to see if the sushi roll pattern could have helped identify turning points over a 14-year period between 1990 and 2004. In the doubling of the period of the outside reversal week to two 10-daily bar sequences, signals were less frequent but proved more reliable. Constructing the chart consisted of using two trading weeks back-to-back, so that the pattern started on a Monday and took an average of four weeks to complete. This pattern was deemed the rolling inside/outside reversal (RIOR).

Every two week section of the pattern (two bars on a weekly chart, which is equivalent to 10 trading days) is outlined by a rectangle. The magenta trendlines show the dominant trend. The pattern often acts as a good confirmation that the trend has changed and will be followed shortly after by a trend line break.

Once the pattern forms, a stop loss can be placed above the pattern for short trades, or below the pattern for long trades.

The test was conducted based on how the rolling inside/outside reversal (RIOR) to enter and exit long positions would have performed, compared to an investor using a buy-and-hold strategy. Even though the NASDAQ composite topped out at 5132 in March 2000 (due to the nearly 80% correction that followed), buying on January 2, 1990 and holding until the end of the test period on January 30, 2004 would still have earned the buy-and-hold investor 1585 points over 3,567 trading days (14.1 years). The investor would have earned an average annual return of 10.66%.

The trader who entered a long position on the open of the day following a RIOR buy signal (day 21 of the pattern) and who sold at the open on the day following a sell signal, would have entered their first trade on January 29, 1991, and exited the last trade on January 30, 2004 (with the termination of the test). This trader would have made a total of 11 trades and been in the market for 1,977 trading days (7.9 years) or 55.4% of the time. However, this trader would have done substantially better, capturing a total of 3,531.94 points or 225% of the buy-and-hold strategy. When time in the market is considered, the RIOR trader’s annual return would have been 29.31%, not including the cost of commissions.

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Using Weekly Data

The same test was conducted on the NASDAQ Composite Index using weekly data: using 10 weeks of data instead of the 10 days (or two weeks) used above. This time, the first or inside rectangle was set to 10 weeks, and the second or outside rectangle to eight weeks, because this combination was found to be better at generating sell signals than two five-week rectangles or two 10-week rectangles.

In total, five signals were generated and the profit was 2,923.77 points. The trader would have been in the market for 381 (7.3 years) of the total 713.4 weeks (14.1 years), or 53% of the time. This works out to an annual return of 21.46%. The weekly RIOR system is a good primary trading system but is perhaps most valuable as a tool for providing back up signals to the daily system discussed prior to this example.

Trend Reversal Confirmation

Regardless of whether a 10-minute bar or weekly bars were used, the trend reversal trading system worked well in the tests, at least over the test period, which included both a substantial uptrend and downtrend.

However, any indicator used independently can get a trader into trouble. One pillar of technical analysis is the importance of confirmation. A trading technique is far more reliable when there is a secondary indicator used to confirm signals.

Given the risk in trying to pick a top or bottom of the market, it is essential that at a minimum, the trader uses a trendline break to confirm a signal and always employ a stop loss in case they are wrong. In our tests, the relative strength index (RSI) also gave good confirmation at many of the reversal points in the way of negative divergence.

Reversals are caused by moves to new highs or lows. Therefore, these patterns will continue to play out in the market going forward. An investor can watch for these types of patterns, along with confirmation from other indicators, on current price charts.

The Bottom Line

Timing trades to enter at market bottoms and exit at tops will always involve risk. Techniques such as the sushi roll, outside reversal week, or rolling inside/outside reversal–when used in conjunction with a confirmation indicator–can be very useful trading strategies to help the trader maximize and protect their hard-earned money.

Reversal Definition and Trading Uses

What is a Reversal?

A reversal is a change in the price direction of an asset. A reversal can occur to the upside or downside. Following an uptrend, a reversal would be to the downside. Following a downtrend, a reversal would be to the upside. Reversals are based on overall price direction and are not typically based on one or two periods/bars on a chart. Certain indicators, such a moving average or trendlines, may help in isolating trends as well as spotting reversals.

Key Takeaways

  • A reversal shows that the price direction of an asset has changed, from going up to going down, or from going down to going up.
  • Traders try to get out of positions that are aligned with the trend prior to a reversal, or they will get out once they see the reversal underway.
  • Reversals typically refer to large price changes, where the trend changes direction. Small counter-moves against the trend are called pullbacks or consolidations.
  • When it starts to occur, a reversal isn’t distinguishable from a pullback. A reversal keeps going and forms a new trend, while a pullback ends and then the price starts moving back in the trending direction.

What Does a Reversal Tell You?

Reversals often occur in intraday trading and happen rather quickly, but they also occur over days, weeks, and years. Reversals occur on different time frames which are relevant to different traders. An intraday reversal on a five-minute chart doesn’t matter to a long-term investor who is watching for a reversal on daily or weekly charts. Yet, the five-minute reversal is very important to a day trader.

An uptrend, which is a series of higher swing highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows. A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.

Trends and reversals can be identified based on price action alone, as described above, or other traders prefer the use of indicators. Moving averages may aid in spotting both the trend and reversals. If the price is above a rising moving average then the trend is up, but when the price drops below the moving average that could signal a potential price reversal.

Trendlines are also used to spot reversals. Since an uptrend makes higher lows, a trendline can be drawn along those higher lows. When the price drops below the trendline, that could indicate a trend reversal.

If reversals were easy to spot, and to differentiate from noise or brief pullbacks, trading would be easy. But it isn’t. Whether using price action or indicators, many false signals occur and sometimes reversals happen so quickly that traders aren’t able to act quickly enough to avoid a large loss.

Example of How to Use a Reversal

The chart shows an uptrend moving with a channel, making overall higher highs and higher lows. The price first breaks out of the channel and below the trendline, signaling a possible trend change. The price then also makes a lower low, dropping below the prior low within the channel. This further confirms the reversal to the downside.

The price then continues lower, making lower lows and lower highs. A reversal to the upside won’t occur until the price makes a higher high and higher low. A move above the descending trendline, though, could issue an early warning sign of a reversal.

Referring to the rising channel, the example also highlights the subjectivity of trend analysis and reversals. Several times within the channel the price makes a lower low relative to a prior swing, and yet the overall trajectory remained up.

Difference Between a Reversal and a Pullback

A reversal is a trend change in the price of an asset. A pullback is a counter-move within a trend that doesn’t reverse the trend. An uptrend is created by higher swing highs and higher swing lows. Pullbacks create the higher lows. Therefore, a reversal of the uptrend doesn’t occur until the price makes a lower low on the time frame the trader is watching. Reversals always start as potential pullbacks. Which one it will ultimately turn out to be is unknown when it starts.

Limitations In Using Reversals

Reversals are a fact of life in the financial markets. Prices always reverse at some point and will have multiple upside and downside reversals over time. Ignoring reversals may result in taking more risk than anticipated. For example, a trader believes that a stock which has moved from $4 to $5 is well positioned to become much more valuable. They rode the trend higher, but now the stock is dropping to $4, $3, then $2. Reversal signs were likely evident well before the stock reached $2. Likely they were visible at before the price reached $4. Therefore, by watching for reversals the trader could have locked in profit or kept themselves out of a now losing position.

When a reversal starts, it isn’t clear whether it is a reversal or a pullback. Once it is evident it is a reversal, the price may have already moved a significant distance, resulting in a sizable loss or profit erosion for the trader. For this reason, trend traders often exit while the price is still moving in their direction. That way they don’t need to worry about whether the counter-trend move is a pullback or reversal.

False signals are also a reality. A reversal may occur using an indicator or price action, but then the price immediately resumes to move in the prior trending direction again.

Reversing Entries

What is a Reversing Entry?

Reversing entries, or reversing journal entries, are journal entries made at the beginning of an accounting period to reverse or cancel out adjusting journal entries made at the end of the previous accounting period. This is the last step in the accounting cycle.

Reversing entries are made because previous year accruals and prepayments will be paid off or used during the new year and no longer need to be recorded as liabilities and assets. These entries are optional depending on whether or not there are adjusting journal entries that need to be reversed.

Why are Reversal Entries Used?

Reversing entries are usually made to simplify bookkeeping in the new year. For example, if an accrued expense was recorded in the previous year, the bookkeeper or accountant can reverse this entry and account for the expense in the new year when it is paid. The reversing entry erases the prior year’s accrual and the bookkeeper doesn’t have to worry about it.

If the bookkeeper doesn’t reverse this accrual enter, he must remember the amount of expense that was previously recorded in the prior year’s adjusting entry and only account for the new portion of the expenses incurred. He can’t record the entire expense when it is paid because some of it was already recorded. He would be double counting the expense.

Example

It might be helpful to look at the accounting for both situations to see how difficult bookkeeping can be without recording the reversing entries. Let’s look at let’s go back to your accounting cycle example of Paul’s Guitar Shop.

In December, Paul accrued $250 of wages payable for the half of his employee’s pay period that was in December but wasn’t paid until January. This end of the year adjusting journal entry looked like this:

Accounting with the reversing entry:

Paul can reverse this wages accrual entry by debiting the wages payable account and crediting the wages expense account. This effectively cancels out the previous entry.

But wait, didn’t we zero out the wages expense account in last year’s closing entries? Yes, we did. This reversing entry actually puts a negative balance in the expense. You’ll see why in a second.

On January 7th, Paul pays his employee $500 for the two week pay period. Paul can then record the payment by debiting the wages expense account for $500 and crediting the cash account for the same amount.

Since the expense account had a negative balance of $250 in it from our reversing entry, the $500 payment entry will bring the balance up to positive $250– in other words, the half of the wages that were incurred in January.

See how easy that is? Once the reversing entry is made, you can simply record the payment entry just like any other payment entry.

Accounting without the reversing entry:

If Paul does not reverse last year’s accrual, he must keep track of the adjusting journal entry when it comes time to make his payments. Since half of the wages were expensed in December, Paul should only expense half of them in January.

On January 7th, Paul pays his employee $500 for the two week pay period. He would debit wages expense for $250, debit wages payable for $250, and credit cash for $500.

The net effect of both journal entries have the same overall effect. Cash is decreased by $250. Wages payable is zeroed out and wages expense is increased by $250. Making the reversing entry at the beginning of the period just allows the accountant to forget about the adjusting journal entries made in the prior year and go on accounting for the current year like normal.

As you can see from the T-Accounts above, both accounting method result in the same balances. The left set of T-Accounts are the accounting entries made with the reversing entry and the right T-Accounts are the entries made without the reversing entry.

Recording reversing entries is the final step in the accounting cycle. After these entries are made, the accountant can start the cycle over again with recording journal entries. This cycle repeats in the exact same format throughout the current year.

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