My grandfather used to tell me he could smell an imminent change in the weather…
He also believed that he could tell when a storm was on the way by watching the behaviour of his pigs.
He did have an uncanny knack of getting it right, but personally, I prefer a more scientific approach – especially when it comes to identifying trends towards market reversal.
Now, there is no shortage of hearsay, anecdotal evidence, gossip and plain old mumbo jumbo about which way prices are headed.
However, I always look for tried and tested price patterns – factors that come up time and time again which can help foretell when a market is on the verge of a trend switch…
Here are three very different signals – each of which can signal that market sentiment is shifting…
3 signals of imminent market reversal
1. The Fear Index
The VIX, also called the CBOE Volatility Index or just the “fear index”, is a tested gauge of investor confidence in the S&P500. In general, if the VIX goes down, stocks are rising; and if the VIX goes up, stock prices are in decline.
So investors looking for market reversals, will be eagerly watching for new trends on the VIX.
We last looked at the “fear index” back in January this year (LINK) when it was in a steady downward trend, and the S&P bull run rumbled on. Stock prices where steadily climbing, and the VIX was steadily falling.
This chart shows the S&P and the VIX from September 2010 until January this year:
The index is looking quite different today – and that downtrend on the VIX is long broken. So, what we’re looking for is signs of a new trend forming on the VIX. It’s early days yet, but there are some higher lows appearing on the VIX charts since May this year:
2. A Head & Shoulders Pattern
The head and shoulders is one of the most reliable reversal chart patterns. It does, however, take some patience to wait for its confirmation.
The pattern looks something like this …
It is a three peak pattern, with the middle peak above the other two. The pattern should look like a person’s head and shoulders (well, a bit like it). The two shoulders should look similar and be close to the same price. Ideally, the right-hand shoulder will be lower.
The neckline is a line that runs through the two “armpits” of the pattern, and confirmation only comes once the price crosses below the sloping neckline.
Of course, head and shoulder patterns aren’t always as tidy as text-book examples. Here’s a chart of the FTSE over the past six months showing a potential head and shoulders pattern taking shape …
Remember, though, the neckline must be broken to the downside for this to be a head and shoulders pattern.
3. Using the Doji
While the head and shoulders pattern shows a longer-term conflict between the bulls and bears, a doji is a very different beast, capturing the sentiment of traders’ indecision in just one candlestick.
A doji is a candlestick with little or no real body. It can have an upper and lower wick, but the closing price should be almost identical to the open price -meaning that it looks like a cross.
What the doji is showing us is that the market opened and closed at the same price – neither the bulls nor the bears got the upper hand. If a doji appears in a bullish trend, it can signal that the bears are coming in. And if it appears in a downtrend, it could signal the bulls rearing their heads.
A doji shows us a wrestling match with no clear winner. It doesn’t give us a big picture of the market, but rather a snapshot of trader sentiment, and as such it is not a trading signal in its own right. It can, however, be the final piece of the puzzle.