Market Reversals and How to Spot Them

Capturing trending movements in a stock or other type of asset can be lucrative. However, getting caught in a reversal is what most traders who pursue trendings stock fear. A reversal is anytime the trend direction of a stock or other type of asset changes. Being able to spot the potential of a reversal signals to a trader that they should consider exiting their trade when conditions no longer look favorable. Reversal signals can also be used to trigger new trades, since the reversal may cause a new trend to start.

In his book “The Logical Trader,” Mark Fisher discusses techniques for identifying potential market tops and bottoms. While Fisher’s techniques serve the same purpose as the head and shoulders or double top/bottom chart patterns discussed in Thomas Bulkowski’s seminal work “Encyclopedia of Chart Patterns,” Fisher’s methods provide signals sooner, giving investors an early warning of possible changes in the direction of the current trend.

One technique that Fisher discusses is called the “sushi roll.” While it has nothing to do with food, it was conceived over a lunch during which a number of traders discussed market setups.

Sushi Roll Reversal Pattern

Fisher defines the sushi roll reversal pattern as a period of 10 bars in which the first five (inside bars) are confined within a narrow range of highs and lows and the second five (outside bars) engulf the first five with both a higher high and lower low. The pattern is similar to a bearish or bullish engulfing pattern, except that instead of a pattern of two single bars, it is composed of multiple bars. 

When the sushi roll pattern appears in a downtrend, it warns of a possible trend reversal, showing a potential opportunity to buy or exit a short position. If the sushi roll pattern occurs during an uptrend, the trader could sell a long position or possibly enter a short position.

While Fisher discusses five- or 10-bar patterns, neither the number nor the duration of bars is set in stone. The trick is to identify a pattern consisting of the number of both inside and outside bars that are the best fit, given the chosen stock or commodity, and using a time frame that matches the overall desired time in the trade.

The second trend reversal pattern that Fisher explains is recommended for the longer-term trader and is called the outside reversal week. It is similar to a sushi roll except that it uses daily data starting on a Monday and ending on a Friday. The pattern takes a total of 10 days and occurs when a five-day trading inside week is immediately followed by an outside or engulfing week with a higher high and lower low.

Testing the Sushi Roll Reversal

A test was conducted on the NASDAQ Composite Index to see if the sushi roll pattern could have helped identify turning points over a 14-year period between 1990 and 2004. In the doubling of the period of the outside reversal week to two 10-daily bar sequences, signals were less frequent but proved more reliable. Constructing the chart consisted of using two trading weeks back-to-back, so that the pattern started on a Monday and took an average of four weeks to complete. This pattern was deemed the rolling inside/outside reversal (RIOR).

Every two week section of the pattern (two bars on a weekly chart, which is equivalent to 10 trading days) is outlined by a rectangle. The magenta trendlines show the dominant trend. The pattern often acts as a good confirmation that the trend has changed and will be followed shortly after by a trend line break.

Once the pattern forms, a stop loss can be placed above the pattern for short trades, or below the pattern for long trades. 

The test was conducted based on how the rolling inside/outside reversal (RIOR) to enter and exit long positions would have performed, compared to an investor using a buy-and-hold strategy. Even though the NASDAQ composite topped out at 5132 in March 2000 (due to the nearly 80% correction that followed), buying on January 2, 1990 and holding until the end of the test period on January 30, 2004 would still have earned the buy-and-hold investor 1585 points over 3,567 trading days (14.1 years). The investor would have earned an average annual return of 10.66%.

The trader who entered a long position on the open of the day following a RIOR buy signal (day 21 of the pattern) and who sold at the open on the day following a sell signal, would have entered their first trade on January 29, 1991, and exited the last trade on January 30, 2004 (with the termination of the test). This trader would have made a total of 11 trades and been in the market for 1,977 trading days (7.9 years) or 55.4% of the time. However, this trader would have done substantially better, capturing a total of 3,531.94 points or 225% of the buy-and-hold strategy. When time in the market is considered, the RIOR trader’s annual return would have been 29.31%, not including the cost of commissions.

Using Weekly Data

The same test was conducted on the NASDAQ Composite Index using weekly data: using 10 weeks of data instead of the 10 days (or two weeks) used above. This time, the first or inside rectangle was set to 10 weeks, and the second or outside rectangle to eight weeks, because this combination was found to be better at generating sell signals than two five-week rectangles or two 10-week rectangles.

In total, five signals were generated and the profit was 2,923.77 points. The trader would have been in the market for 381 (7.3 years) of the total 713.4 weeks (14.1 years), or 53% of the time. This works out to an annual return of 21.46%. The weekly RIOR system is a good primary trading system but is perhaps most valuable as a tool for providing back up signals to the daily system discussed prior to this example.

Trend Reversal Confirmation

Regardless of whether a 10-minute bar or weekly bars were used, the trend reversal trading system worked well in the tests, at least over the test period, which included both a substantial uptrend and downtrend.

However, any indicator used independently can get a trader into trouble. One pillar of technical analysis is the importance of confirmation. A trading technique is far more reliable when there is a secondary indicator used to confirm signals.

Given the risk in trying to pick a top or bottom of the market, it is essential that at a minimum, the trader uses a trendline break to confirm a signal and always employ a stop loss in case they are wrong. In our tests, the relative strength index (RSI) also gave good confirmation at many of the reversal points in the way of negative divergence.

Reversals are caused by moves to new highs or lows. Therefore, these patterns will continue to play out in the market going forward. An investor can watch for these types of patterns, along with confirmation from other indicators, on current price charts.

The Bottom Line

Timing trades to enter at market bottoms and exit at tops will always involve risk. Techniques such as the sushi roll, outside reversal week, or rolling inside/outside reversal–when used in conjunction with a confirmation indicator–can be very useful trading strategies to help the trader maximize and protect their hard-earned money.