Earlier this week I wrote about a trend reversal gap, indicating what it is and that it is one of my more favorite technical chart patterns. Today I'll follow up on why the pattern is generally so effective.

We all know that what goes up must come down and in the stock market the opposite is usually true as well. There is a natural ebb and flow to the markets, a stock moves up, pulls back a bit, moves higher, pulls back a bit and moves higher again. When in a down trend, a stock drops, then bounces slightly and then drops again, bounces slightly, drops again....

This ebb and flow gives investors a change to react and take profits and wait for the next entrance signal again.

When a stock is in a down trend, this same ebb and flow process is still at work but on a longer time frame. Instead of dropping and bouncing every week or so it may drop and bounce every few months (even though smaller ebb and flows are still apparent within the chart.)



Now taking this same chart you can also see the smaller moves within the longer moves. These are represented with the numbers. The was a drop from the number 1 to the number 2, there was another drop from the number 3 to the number 4... These are the smaller ebb and flows within the larger ebb and flow trends.



My goal here is not to get hung up on these trend but to explain why a trend reversal gap trade works. So once we understand that there is a natural ebb and flow to the market we can start to understand why a down trending stock does not trend lower forever. At some point investors start saying to them selves, this stock has to bounce soon and I'll be looking for a short term entrance to buy as soon as it ebbs again.

So what might cause a stock to ebb (bounce from within its down trend)? How about some positive news? And if the news is so good that it causes a stock to gap higher at the open and close near its high for the day, this is exactly what  we will be looking for.

Positive news is always good and if the news is exceptional enough that it will cause plenty of buying early on, this will make the stock open higher than it closed the previous day. This is the gap open part of the trade.  Now at some point investors will start to say to themselves, "Hey wait a moment, let's not get too excited, remember this stock is still in a down trend" This would then send the stock back down, but if the stock does not pull back before the end of the day, and in fact continues to see buying right up into the close, it is telling us that the news was positive enough to keep the stock moving higher for the next couple of weeks. 

We now have ourselves a trend reversal gap and an extremely strong entrance signal.

Look at the chart below to see what generally happenes after a trend reversal gap.


Remember for these to work correctly, you need the stock to be in either an uptrend or down trend and gap open in the opposite direction the next trading day. A sideways trend will not work for this trade setup. 

Now that you know the technical set up for a trend reversal gap, paper trade these to see what type of trade works best for your trading style. If the gap opened in the same direction as the overall market trend then, I usually like a straight call or put trade. If it opened up in the opposite direction then I like a short term spread.

Cheers,
Mike

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