The intermediate-term trend of the broader markets continues to track higher, with investor confidence positive. But while traders have also benefited from the rally, in the back of many of their minds is the fear of reversion. It's a natural component of the backing and filling process, but after such a strong rally the threat of a normal reversion gaining momentum and becoming a serious correction is a concern.
But traders shouldn't predict, they should profit from price action. One way to screen for reversion plays and capture short-term moves is to use oversold momentum indicators and candlestick patterns.
Shares of 3M (MMM) are up more than 100% since their October 2011 low. The daily chart shows the formation of a doji star in Friday's session. A doji candle has a very narrow opening and closing range and represents indecision or a tug-of-war between buyers and sellers. The relative strength index is a common momentum indicator and on this chart it is overlaid with a 21-period average. The combination of a stock being overbought and indecisive price action suggests that it is due for a pullback of some degree. In the past, similar coincident indications have seen tradable reversions. The Bollinger bandwidth indicator at the bottom of the chart shows a wide diversion in bands, which often has signaled a return to the mean.
Perkinelmer (PKI) provides services and solutions to the diagnostic and research markets. The stock recently broke out of a three-month channel consolidation pattern. In the prior trading session a doji candle formed and the relative strength indicator entered an overbought condition. The thing to remember with the doji and relative strength index technical pairing, and just about any other purely technical indicator, is that there needs to be a price action trigger to initiate the trade.
The chart of television content provider Scripps Network Interactive (SNI), illustrates one of the most common of the price triggers: the simple trendline. The stock is clearly oversold, a doji formed in the previous session and the Bollinger bandwidth indicator is at an extreme reading. But momentum oscillators can stay overbought or oversold for long periods and candlestick formations need confirmation. The trigger is the uptrend line drawn off the recent lows. A break below it in lower candle range signals a short-slae trade.
It must be remembered that while these types of trades can develop into deeper reversal moves, they are counter trend and a quick profit or loss is the prime objective.
