A reversal is any substantial price movement that occurs against the prevailing trend. Of course this makes any reversal very much in the eye of the beholder, without any strict absolute or proportionate requirements for a price movement to be defined as a reversal, but the general principle of a significant movement against a recognized existing trend holds.
Some other common terms for reversals include “correction” and “paring gains” (or losses).
The Anatomy of a Reversal
This occurs when there is a sharp rejection of a strong existing trend. Reversals are most often the products of either a correction in the information or perspective that drove the initial trend or a period of profit taking, consolidation or buying in, where the sharp price change of the trend has led to a substantial amount of trades in response.
Trading a Reversal
Almost every trend, no matter how strong, will inevitably see periods of a pullback. These can be great opportunities to either take small profits or to position trades to take larger profits from the continuing trend.
For example, a sharp price increase in a stock from $100 to $110 based on positive news may see a quick reversal to $105 as a result of initial traders taking quick profits and moving on. However, subsequent traders are likely to continue buying the stock for a longer holding period throughout the day based on the positive news, so the price is likely to increase back to $110 and beyond.
This reversal presents traders with a variety of opportunities, from shorting the sharp initial price increase down to $105, taking a quick profit as the price continues its upward trend after the reversal or using the bottom of the reversal as the starting position for a long-term holding trade.
Reversals are an extremely common feature in the landscape of the markets, and being able to recognize and trade them should be an essential component of every traders toolkit.