In this week's Educational Bonus I've decided to cover the one-day pattern known as the Key Reversal. It's important to discuss this pattern because of the myriad of misconceptions regarding its value and definition.

Other frequently-used names for key reversal include "one-day reversal" and "reversal day." These are all the same; don't let anybody tell you otherwise! Regardless of what you refer to it as, the definition of a key reversal is:

Following an uptrend, any day in which a new high is made, yet prices close near their lows (and preferably on high volume).

Following a downtrend, it is any day in which a new low for the trend is made, but prices close near their daily high (again, preferably on high volume).

Note that the definitions above do not contain any mention of the following (these are common misconceptions about key reversals):

• Requirement for the market to close down at the end of an uptrend.
• Requirement for the market to close up at the end of a downtrend.
• Requirement that the day be an outside day (an outside day is when both the high and the low fall outside the previous day's trading range).

Please note that the idea that prices do not reverse is a bit controversial. Many technical analysts would disagree with this definition, but if you go back to the earliest books on the subject, you will find that a down day following an uptrend, or an up day following a down trend, are not required in order to have a key reversal.

As you can no doubt guess, this pattern is one of my pet peeves. Many Internet dictionaries say that an outside day is required. They also make it sound as if a key reversal day is a rare occasion and something to behold. It isn't. Moreover, the trading record of key reversals, though profitable, is not necessarily spectacular. In fact, Edwards and Magee (authors of the highly regarded classic text -- Technical Analysis of Stock Trends) state that key reversals are short-term trading patterns only.

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.

HOW TO TRADE A KEY REVERSAL
The rules 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 suggest waiting for the next key reversal in the opposite direction. However, I would 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.

CONCLUSION
Key reversal days are one of the most overrated patterns in technical analysis. Many so-called experts and authors do not even know the proper definition for this technical term, and many websites have continued to promulgate similar misinformation.

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 (once you know the correct definition) and to execute.

Steven Poser
Editor
The ETF Authority
New York, NY