One-Day Reversals

One-day reversal patterns are a powerful & reliable technical indicator. Such chart patterns accurately signal imminent market turns for astute technicians. However, the very nature of such market action commonly catches traders buying at the top or selling near the bottom of markets about to change direction.

Why is that? Simple. One-day reversals or "island reversals" that cover several sessions are not what they seem. Most traders would view a price gap to the upside as extremely bullish while a gap lower seems very bearish. Basic logical deduction, isn't it?

When prices pop to new recent highs everyone wants to buy. Traders fear missing out on the next big rally and will chase a stock as prices seem to run away. Soon they find the market they chased has now slid back to them and often beyond.

Prices plunging to recent lows can scare even the boldest traders away from buying. Never reach for falling knives, remember? That's a good rule to trade by but we must remain watchful of the next session's behavior. Today's falling knife might be tomorrow's escalator up.

Market sentiment behind such moves may be vastly different the very next day. Let's explore actual examples to dissect this simple contrarian indicator:

(Daily chart, CIEN)

This daily chart of CIEN clearly shows a few "doji" (stalemate) candle patterns near the top and bottom of continued price moves. As discussed in our candlestick lesson, the daily candle in late March visibly shows where buyers pushed prices to new highs during the session but were unable to hold that lofty level.

By the same token, doji candles appearing near short-term bottoms in April and May prove that sellers pushed prices down far as they could but new buying took over and closed the market higher for the day.

In each case we witness an extreme change in market sentiment occur relative to that over the last few sessions. From there we can expect this new sentiment to continue but need verification for prudent traders to enter the fray.

(Daily chart, CSCO)

CSCO formed an outside day prior to earnings release and closed neutral to it's daily high and low. Considering prices advanced 12+% from an intraday low near $58 days before, we might guess this is a strong sign of price exhaustion.

That fact together with CSCO failing to break technical resistance at $70 are two strong clues to the next day's market direction.

(Daily chart, WMT)

Wal-Mart exhibits doji patterns near areas of technical support after recent price declines. Again, the single-day duel to a draw between buyers & sellers indicates a turn in sentiment and consequently market direction is imminent.

(Daily chart, YHOO)

YHOO shows us a classic example of the perils in buying too soon. It took three outside days near the earnings release in July before this stock committed to it's reversal. Can you see where buyers jumping in long near the first candle at $118 were burned by it's flame later on?

Outside days and doji candles are not proof that the market will turn; they are merely strong evidence. We need to see confirmation from other technical studies to verify this. Such might include increased volume in the price reversal's direction, penetration and release from Bollinger band extremes, MACD, stochastic or other oscillator signal, Advance/Decline and numerous other studies.

Reversal days are indeed highly-significant market direction tools when noted and viewed accordingly.

(Daily chart, DELL)

Even the biggest-cap stocks with small-range moves aren't immune to this behavior. On display are three one-day reversals marking several point moves.

Can you see a clear doji near June 6th after a fall in price from $51+ to $42? What might that denote as verified next day with a white engulfing candle? If you bought near $44 based on that, what would be your results?

One more 10% price move is apparent on the chart. Can you find it? (hint; a white hammer in early July)

One-day reversals are key moments in the market for traders to identify and position themselves in front of.