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When a reversal occurs on a chart on a heavy volume, it is supposed to signal the beginning of a strong reverse trend. For example, if a security was trending upwards and then it moves down on heavy volume, we will assume that the downward trend is strong because of heavy selling pressure, as stated here (the paragraph titled "Volume").

But when I look at a downward reversal on heavy volume, I think that many people are selling. In other words, whoever wanted to sell has already done it, so now the trend will discontinue. Why is the logic flawed?

Dheer
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Victor123
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    Considering that studies have found that relying on head-and-shoulders patterns to make trading decisions is worse than randomly making a decision, I'd be careful about reading too much into it and similar patterns. – John Bensin May 31 '13 at 21:47
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    What a head and shoulder indicates is that a trend could be ending as it will have a lower high (in an uptrend) or a higher low (in a downtrend). – Victor May 31 '13 at 21:55
  • @Sulla TA indicators make for interesting subjects to study; I always feel obligated to mention head-and-shoulders patterns because when I briefly shadowed someone in the pit at CME (they're still using open outcry), H&S patterns were the basis for numerous jokes and puns (which I don't care to repeat). – John Bensin May 31 '13 at 22:02
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    @JohnBensin lol, yeah. i always wonder where all the t/a guys are on the forbes richest. supposedly hft does a lot of custom t/a, but we still have yet to see a real master of the universe in the wild –  May 31 '13 at 22:04
  • @Victor "could" being the operative word here. The point that studies have made is that when using head-and-shoulders patterns, flipping a coin is a better indication of trend ending. – John Bensin May 31 '13 at 22:04
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    @Sulla To be fair, firms that mix the TA indicators that can be defined quantitatively, and therefore tested objectively (so basically, firms that use quantitative finance) are some of the most profitable financial companies around. The problem with TA is that while it may still work in smaller markets, the increasing penetration of technology reduces the ability of the TA indicators (that work) to earn returns for retail traders. – John Bensin May 31 '13 at 22:07
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    @JohnBensin - what are these studies looking at - the percentage of times a head and shoulders eventuates in the desired outcome? Did they look at just H&S patterns by itself or did they incorporate it with other information? If I saw a H&S forming and I was long in a stock I would become cautious that things might be changing, I could then monitor that stock more closely and maybe tighten my stop on it. If I was to trade based on the pattern I would first look for confirmation that it does eventuate before entering (meaning I would miss all the failed patterns). Do the studies consider this? – Victor May 31 '13 at 22:16
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    @Victor Aaronson's book does, I believe. I referenced it and the Lo, et al. study in this answer, so if you're interested, that might be a good place to start. Aaronson's book considers a whole range of patterns and their application in combination; I haven't picked it up in about a year and I don't have a copy handy, but if you're interested in looking at empirical evidence for and against TA, start there. – John Bensin May 31 '13 at 22:24

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You have to look at the whole picture. What is happening to volume prior to the reversal? How long has the trend been going for? Is there any divergence between price and momentum before the reversal commenced? Have there been any bad reports by the company or any bad new stories? What is happening to the market as a whole?

When a reversal happens on heavy volume it may indicate that sentiment has changed, the bulls have been exhausted (no more buyers in the market), and the bears are taking charge (sellers starting to take profits). This effect may cause panic in other security holders and cause them to sell. Then you get other holder's stop losses being triggered and shorters entering the market. If this continues it can cause panic and fear throughout security holders and cause the downtrend to accelerate. Think of it as an uptrend climbing up stairs and a downtrend falling off the cliff at the top. Fear tends to be a stronger emotion than greed.

Something else to look out for just prior to the reversal is intraday highs not holding up by the close. If you look at a candlestick chart this is illustrated by long wicks on the up side with small real bodies. This may indicate that the bulls are trying to push the price higher during the day but the bears push it back down by the close. This is another indication that momentum in the uptrend may be drying up, especially if it occurs over a few consecutive days. If you get this behaviour followed by a drop in price on large volume, it may be the start of a steep reversal.

Victor
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