Wall Street is chock full of investment idioms, but perhaps none is so broadly quoted as “cut your losses short and let your winners run.”
Easier said than done.
But how, in fact, is an investor to know whether a stock is merely retracing against an existing trend, or if the trend has outright reversed?
Successful investing is predicated on knowing the answer to that question.
Let’s look at a chart now to help us define precisely the difference between a retracement and a reversal.
This is gold miner Kinross Gold Corp. (NYSE: KGC) for just over three years. In red, the broad trend is outlined: bullish for the first 12 months, followed by a full 24 months of bearish action. The reversal occurs in October 2009, with the highs of nearly $24. From there on out, the shorts are in control.
But there are several periods where the stock retraces against the prevailing trend (outlined in blue). These last anywhere from one to four months (in this example) before eventually succumbing to the pressure of the bear.
So how do we know which is which?
From experience, we can vouch that a countertrend rally is among the most difficult trades to profit from, and unless a trader has distinct trend lines, strongly trending moving averages or an established Fibonacci retracement calculation against which to trade, he’ll find it well-nigh impossible to take his trade to the bank.
There are a few ways of identifying a change in trend, and below we identify them.
We start with a chart of three years’ worth of Exxon Mobil (NYSE: XOM), because it offers a textbook example of the “three wave” fan pattern – a technique that provides a very reliable reversal signal.
Have a look:
Drawing the three fan lines (in red) is a simple matter of connecting the top with successive retracement highs. They generally fall equidistant from each other and offer a reversal signal when price breaks away from the third line (black arrow).
Here’s a chart of the VanEck Vectors Gold Miners ETF (NYSEArca: GDX) that illustrates the three wave fan pattern in reverse:
There are no signs of a volume surge here to support the three-wave pattern, and, in retrospect, none was needed. The breakdown and subsequent decline lasted for years and was immensely profitable for those who rode it.
In addition to three waves on increased volumes, traders should also consider the following indicators as signs that a trend reversal is occurring.
- Chart Patterns – There are a number of technical formations that signal a reversal in trend, and they include (but are not limited to) head-and-shoulders patterns, double (or triple) tops, wedges and rounded bottoms. While we don’t have the space here to discuss these in depth, click on the links above for more detailed explanations.
- Short Interest – Major reversals are often preceded by a general increase in short interest.
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