Markets tend to give off warnings and clues as to when they are about to change trend, even if this trend is to be a short lived correction rather than a major trend reversal. Some of these patterns are easy to spot, while others are more subtle. There are many different methodologies for detecting and assessing reversal signals, the most common method is that of swing trading which is complicated and is based on the principle that the market will yield a buy signal when a previous high has been breached, and it will yield a sell signal when a previous low has been breached. The problem with swing trading methodology is that things become confusing and ambiguous from time to time. The swing highs and lows are hard to assess and qualify as valid swing points, and the way the market breaches these levels is also sometimes unclear.
Traders use all kinds of techniques and methods in order to filter out false signals and ambiguous patterns, sometimes it is possible to do so, and sometimes markets will be so confusing that nothing can see clearly through them. In the case of swing trading for example the market can appear to be breaching a previous swing high or low, and then over the next two days it may reverse once more back to its previous trend, trapping traders on the wrong side of the market. So the use of all powerful analysis methods, such as divergences, swing points, and all kinds of indicators may or may not work.
Some of the leading indicators are chart patterns and divergences, these carry a lot of weight but cannot pinpoint the exact reversal. The 200 hour moving average can be used in this case, if the market is really about to reverse there will be a momentum breakout, following the breach of the 200 hour moving average. The reversal process may continue up until the 200 day moving average is tested, and then the market can still go either way. Another reversal pattern, which is strictly chart based, is the outside day pattern. The outside day pattern is formed by a single day which has huge trading range and exceeds the previous day’s high and low. If the outside day is a down day, then traders consider it as a negative indicator and expect the market to fall in the coming days. If the outside day is an up day then they expect the market to rally in the coming days. Outside days are used as a confirming indicator, in order to confirm readings on other indicators and patterns, such as moving averages and divergences where the potential for a reversal has been spotted. The outside day, if it shows up on the charts, can pinpoint the exact day of reversal. If no outside day exists, then traders must look for other patterns.
The above chart shows a series of up and down outside days, and how one could use them as a confirming indicator. Outside days are a kind of chart pattern that will not work on its own, even though chart patterns are very powerful and can override off chart indicators, the outside day is formed by a single trading day’s action, and hence sometimes it does not work. In such cases an outside day will appear, but the market will not really reverse.
Despite the weaknesses of the outside day pattern, it is used by many traders all the time. The same traders also use trend line analysis, moving averages and more indicators. But there seems to be an inverse relationship between indicator significance and its ability to pinpoint market reversal time. Indicators that are powerful have poor timing, and indicators such as the outside day are weak, but have perfect timing.
So in order for traders to make more sense of the markets, which by their nature are confusing and follow no perfect predictable pattern, they have to combine the benefits of different indicators and chart patterns. And they have to realize that only a portion of these indicators and patterns are relevant to the market at any one time. The market is also influenced by external fundamental factors some of which are very difficult to understand. Fundamentals are complicated and they can even have a double impact on the market, such as a positive impact for the next 30 days and at the same time a negative impact for the next 3 months, all caused by the same economic report. This is only part of the reason why markets are confusing and swing trading methodology fails many times. So that even though the market gives off a valid buy signal now, and it may rally for a week, it can perfectly decline, out of the blue, at some later time.
Traders must know when or at what level they should get out of a trade. Knowing when to exit the market is just as important as when to enter that market. Because as usually, markets can go in the predicted direction, but will do so in the most confusing way possible, and some indicators will be wrong, indicators never agree, and even chart patterns never totally agree on market direction.
