Trying to time a reversal is tricky business—they’re much easier spotted in hindsight.
Tony Stock via Shutterstock; Canva
What Does It Mean When an Asset Experiences a Reversal?
Within financial markets, a reversal is said to have occurred when the direction of an asset’s price movement changes. For example, if a stock has been falling in price fairly consistently for a month or so, then it suddenly begins to go up in value for a sustained period, that stock could be described as having experienced a reversal. The same goes for a stock that has been going up in price for a year and then suddenly begins to lose value.
Reversals are most commonly discussed in reference to stocks, but other asset types like bonds and commodities can experience reversals as well. It’s important to note that reversals can refer to changes in the trend of an asset’s price movement in either direction—to the upside or the downside.
Reversal vs. Pullback: What’s the Difference?
Reversals should not be confused with pullbacks, which are shorter-term changes in the direction of an asset’s price movement that occur for a short time before the original trend resumes. For instance, if the price of oil has been falling for three months, then it goes up for three days before beginning to fall for another month and a half, the three days of contrarian price action would represent a pullback in a downward trend—not a reversal.
As long as there is a sustained trend in one direction, a turning point, then a sustained trend in the other direction, a reversal has taken place. But just what does “sustained” mean in this context? That depends entirely on the time horizon of the observer.
A day trader might look for signs of a reversal within a single trading session. For instance, a stock going up in price for three hours before falling in price for the remainder of the day’s session might be described by a day trader as having experienced an intra-day reversal. Longer-term investors, on the other hand, might look at trends on a much larger scale, like several months or a year. In this sense, what qualifies as a reversal to one investor might simply be a price blip or a pullback to another.
The problem with differentiating a true reversal from a mere pullback—on any time scale—is that it can only be done in retrospect, once enough time has passed to determine whether the change in price direction was sustained or temporary.
Reversal and Pullback Examples: Tesla
The graph below displays the price of Tesla stock from early November 2021 to early November 2022. Stars represent reversals, while triangles represent pullbacks, or temporary price swings that are contrary to longer-term trends. For the sake of space and clarity, not all price trend changes have been marked with symbols.
This chart shows Tesla’s stock price from early November 2021 to early November 2022. Reversals are marked with stars, while pullbacks are marked with triangles.
Remember, what qualifies as a reversal vs. a pullback depends on the time scale in question. In this case, we’re looking at an entire year. To a trader with a much shorter time horizon, many of the pullbacks marked on this chart would actually represent reversals—it’s all a matter of perspective, and an investor or trader’s perspective typically depends on how frequently they like to buy and sell.
Do Reversals Usually Happen Near Support and Resistance Levels?
Traders who use technical analysis spend a lot of time examining established support and resistance levels for the stocks they are interested in. These are the lower (support) and upper (resistance) price levels between which a particular stock or security tends to trade.
These levels can be horizontal (static) or diagonal (dynamic) depending on the preference and time horizon of the observer. Two different investors might easily draw different support and resistance lines depending on their respective time horizons and whether they prefer to use static or dynamic lines to represent support and resistance.
All this being said, support and resistance levels do often mark the prices at or near which a stock is likely to reverse the direction of its price movement. In some cases, however, a stock may continue an upward or downward trend through an established support or resistance level in what is known as a breakout. Once a breakout occurs, it is not uncommon for a previous support level to become a new resistance level or vice versa.
Since stocks often break out of established support-resistance channels—and since stocks often experience reversals within those channels without falling all the way to support or rising all the way to resistance—attempting to time breakouts using support and resistance levels alone is not a very prudent trading strategy. Keeping these levels in mind while analyzing other technical indicators can provide a more holistic view of whether a reversal might be likely.
What Are Some Signs of an Impeding Reversal?
Some traders like to draw trend lines that connect a stock’s intermediate lows during a longer-term uptrend (or intermediate highs during a longer-term downtrend). These are called trend lines. If a stock’s price breaks through one of these longer-term trend lines by a decent margin, some traders take this to mean that a reversal is occurring, and it’s a good time to buy (if it’s a reversal of a downtrend) or a good time to sell (if it’s a reversal of an uptrend).
Using trend line breakthroughs alone to predict reversals is far from foolproof, though. Prudent traders examine support and resistance levels and trend lines along with data from momentum oscillators like RSI or MACD and other technical indicators to make informed predictions about potentially impending reversals.
