It may not seem like much when a stock erases gains and ends up making a small price change, but to chart readers that's an ominous sign.
Negative price reversals are classic signs of trouble and important clues for chart readers who can recognize them.
Bearish reversals show up on charts as long price bars with the close occurring near the low of the bar. Early gains or new highs are surrendered, and the stock closes with a loss or barely up in price. Either way, the reversal indicates that buyers yielded to a stronger wave of sellers.
A series of these bearish reversals on a daily or weekly chart often marks a top. This signal can occur after a prolonged advance, warning investors that it's time to take profits. They may also show up while a base is forming, perhaps telling chart readers of underlying weakness in the pattern.
Negative reversals that occur in heavy volume are even more worrisome.
Sometimes, reversals are found in long price bars that are part of a volatile trend in the stock. In other words, the stock has become wide and loose, which is another sign of weakness.
The 2008 chart of Sohu.com (SOHU) included negative reversals that warned investors that the stock was topping. The China-based Internet portal operator was posting triple-digit profit gains, thanks largely to its fast-growing online games business.
Yet the stock peaked in early June of that year with a bearish reversal and another one two weeks earlier 1.
The Internet company tried to form a base, but downward reversals kept hampering its progress. Another negative reversal occurred in the week ended June 20 2, when an early 6% gain evaporated by week's end.
In September, three out of four weeks were also bad reversals and the stock finished near the week's low 3. By this time, Sohu was collapsing into a long-term decline. A breakout attempt about a year later fizzled, resulting in more losses.
What about the weeks when the stock closed high in its price range? Weren't those positive reversals and signs of strength
Not quite. Notice that in most of those weeks, the stock didn't necessarily reverse higher; it never had a loss from which to recover. That's a key distinction: A reversal happens only when the price starts going sharply in one direction but ends up the opposite way.