The easiest way to spot a trend reversal is using moving averages.
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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.
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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.
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.
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.
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.
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