November 15th, 2010

Debunking Reversal Days – Again

First the definition (according to TradersLog, one of many similar references I could have picked): a key reversal day is when

“in an uptrend, prices open above the previous day’s close, make a new high and then close below the previous day’s low. In a downtrend, prices open below the previous day’s close, make a new low and then close higher than the previous day’s high. The greater the price range and volume on the key reversal day, the more reliable the signal.”

But what, exactly, is a “reversal day” supposed to signal? A move over the next week, next month or next quarter? Is the move that is supposed to have been signaled to take place starting on the next day? next week? I just don’t know so I thought I’d go back to over the last 12 months to see how many reversal days there actually were in the market and to visually see what happened after that “key” day. They’re color coded on the chart below (click on image to enlarge):

I found seven reversal days; three were bearish reversal days and four were bullish. True, the bearish reversal days of December 31 and June 21 were followed by 7-8% declines but that’s tempered by the fact that those declines lasted less than 20 trading days and were followed by rousing bull markets that weren’t signaled by Bullish reversal days. Furthermore, the Bearish Reversal Day of December 3, 2009 wasn’t followed by a market decline. The record of the Bullish Reversal Days is just as sporadic.

I’ll stick to old-reliable trendlines and moving averages. Give me an old-fashioned head-and-shoulder pattern like the one that marked a recent bottom with the neckline at 1128 or a trendline going back 6 years with 10 pivot points bouncing off of it like the one at 1220.

So if you hear the talking heads in the future prattle on about the day’s trading marking a “reversal day” quickly hit the mute button because it means nothing more than scrambling for headlines.

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  • Anonymous

    EWZ chart is leading SPX, it seems to be cleaner & less manipulation..

    do you own ewz?

  • Joe

    I don't own any EWZ today but did in the past. I'm not sure about "cleaner" and "less manipulation" since they are very similar only EWZ is much more volatile.