Gauging Market Speed and Reversals

Traders aim to catch trends early and ride them to the end. To accomplish this requires incredible timing on both entry and exit levels. Great traders recognize when a market has moved too far, too fast. When the speed of a rally or decline far exceeds the norm, odds increase for a period consolidation or a reversal of direction. Reversals also occur when a market runs out of steam.

Market Phases

Prices trend, consolidate, trend and consolidate again. These phases are constant and repetitious in all markets. This is the circle of trading and gauging speed is an integral part of developing trade strategy. Markets were created to facilitate trade. When a market moves in a direction and the day ranges and volume decrease it is not facilitating trade. As volume decreases opens and closes tend to be near each other (small candlestick bodies). Subsequently, a reversal often occurs. Another type of reversal comes when the pace of a rally or decline surpasses the normal speed. This is commonly known as an overbought or oversold condition.

Technical Tools for Gauging Speed

Many analysts use technical indicators to track the speed of a move. The most popular are RSI (Relative Strength Index), Stochastics and MACD (Moving Average Convergence Divergence). When RSI or Stochastics get above 80 a market is thought to be overbought. On the other hand, a reading below 20 signals an oversold situation. One problem with these indicators is that a market may hang around that 20 or 80 level for weeks. This makes timing a reversal a tough task. In fact, RSIs are more effective when used to determine trend strength. Stochastics are more reliable when looking for a trend reversal indicator. MACD is best used to determine when a market has moved too far, too fast or when it is wound too tight, thus increasing the odds for a breakout.

Average True Range Speedometer

Traders become more skilled at picking tops and bottoms if they are familiar with market dimensions, otherwise known as ATR (average true range). By referring to benchmark ranges we can determine when the speed of a move has become too rapid, thus favoring a consolidation phase or possible trend change.

For a short-term gauge I often refer to an average day range over the past 20 days. If a day range spans more than 175% of the daily 20-day ATR in a 24-hour period, it is considered too quick. In this situation probabilities shift to favor a period of consolidation or change in direction. Another indication of a pace problem (overbought/oversold) is to identify when a market has moved the length of an average week (9-week ATR) in a 48-hour period. Extraordinary ranges frequently occur as trends near exhaustion and subsequently are also common just before reversals.

Strategy Using Speed

If you prefer a contrarian approach when trading or if you prefer to sell option premium, search for markets that are overbought/oversold. Option traders who prefer to collect premium should hunt for markets that exceed normal speed limits. Good timing can have a huge impact on profit and risk. Recognizing severely overbought/oversold signals will enhance your odds of picking off extreme highs and lows for both entry and exit trades.

John Seguin, Market Taker Mentoring

Trader Education