What it is:
A key reversal is a one-day trading pattern that may signal the reversal of a trend. Other frequently-used names for key reversal include "one-day reversal" and "reversal day."
How it works/Example:
Depending on which way the stock is trending, a key reversal day occurs when:
In an uptrend -- prices hit a new high and then close near the previous day's lows.
In a downtrend -- prices hit a new low, but close near the previous day's highs.
The greater the price range and volume on the day that this occurs, the more reliable the signal will be.
The chart above of the S&P 500 top in September 2000 shows an example of a key reversal day. Note that volume was huge and that prices actually closed higher on the session. The bottom in October 1998 (not shown) after the Long-Term Capital Management debacle also was a key reversal even though prices closed lower that day. The low in October 2000 (shown) is also an example of a short-term reversal day.
The rules for trading a key reversal couldn't be simpler. For a bottom, buy at the next day's open and place your stops just beneath the prior low. Edwards and Magee (authors of the highly regarded classic text -- of Stock Trends) suggest waiting for the next key reversal in the opposite direction. However, others look for the first challenge of a major resistance area that fails for a retest. This could be a moving average, trendline, horizontal support or prior gap.
The rules for a key reversal top are to sell on the open following the reversal and to place stops just above the prior day's high.
Why it matters:
Like other technical analysis patterns, being able to predict a turn in a trend adds one more tool investors can use to find portential entry and exit points.
The pattern can provide for early entry into reversals, but without confirmation (such as from momentum divergences), trading key reversals can prove to be a very high-risk strategy. The ease of entry though, and the clear rules associated with trading it, make the pattern a simple one to identify and to execute.