Key Reversal Myth

Alexei Bocharov

Introduction

Quoting [1] : A key reversal bar is a specific version of a one-bar pattern that in certain
situations can signal a price reversal. It represents an exhaustion move- a last gasp of
momentum that occurs after a significant run-up or sell-off in price.

In general terms, a reversal bar top occurs in an uptrend when price makes a new high,
but then reverses to close sharply lower, indicating a switch from bullish to bearish
momentum. (Conversely, a reversal bar bottom occurs in a downtrend when price
establishes a new low for the move, but then reverses to close sharply higher. )

Example: Donward Key Reversal in CRS on 5/21/2008. Upward trends in OHLC and 9-
day Moving Average get snapped after DKR and never recover.

Nice example and fine theory, but, does it make money?

In this short essay I strive to show that, statistically speaking, the significance of the key
reversal signal was being seriously exaggerated.
Definitions

Given a series of OHLC (Open, High, Low, Close) stock price bars, a Downward Key
Reversal bar is defined relative to a previous OHLC bar, as a stock price bar with the
following properties: Open > previous Open, High > previous High, Close < previous
Low.
Informally this is described as an event of severe change of market sentiment within the
respective trading period with stock opening higher than the prior close, establishing new
high but then closing lower than previous low (this obviously implies that the period low
is also lower than the previous Low).

Example: A close up of a downward Key Reversal (KWK on 5/19/2008)

Symmetrically, an Upward Key Reversal bar is defined as an OHLC where Open <
previous Close, Low < previous Low, Close > previous High.
It is traditionally believed that a key reversal is a sure signal of a trend reversal:
assuming a Downward Key Reversal happens against an established upward trend or a
sideways trading pattern, it is taken as a sure sign that a downward trend is about to set
in [2,3,4]. Conversely, if an Upward Key Reversal happens against a downward trend or
sideways trading pattern, then this would be a sure sign of an upward trend about to
begin.

Upon a closer analysis, the predictive power of a key reversal turns out to be a traders
myth.

Analysis

I have analyzed about 600 instances of 1-day downward Key Reversal bars for about
1470 stocks on a somewhat modified Standard and Poors 1500 list for the first half of
year 2008. As summary statistics below shows, a key reversal is not a predictor of a
lasting trend revision. Its value as a 1-day trading signal is equally doubtful.

For symmetry reasons this experiment was limited to downward key reversals (DKR)
happening against an upward trend or a sideways pattern.
I have investigated all the occurrences of DKR across the market of Standard and Poors
1500 size throughout the first half of year 2008.
There were a total of 612 incidents of such downward key reversals.

Let us denote DKR.Close the closing price on the key reversal day.
Across the described sample DKR bars:
1) The probability that the next day closing price is lower than the DKR.Close has
been 49%
2) The probability of seeing the lower close on the second day after DKR has been
approximately 47%
3) For the seventh day after, this probability is seen tapering off to approximately
43%

This is consistent with visual inspection of trends which was done randomly in
approximately half (or about 300) of the instances. I have concluded that the long term
downward trend would set in only about 23% of the cases. (OHLC bar patterns were
examined along with 9-day simple Moving Average curve to arrive at this conclusion.)
In about 10% of cases a sideways trading pattern would emerge in place of the upward
trend.
In approximately 16% of the inspected cases there would be a short-term dip in prices
with immediate recovery of the upward trend.

It is curious that in about 2% of cases the DKR day would actually result in strengthening
of the upward trend. In about 35% of cases there was no visible effect whatsoever on the
OHLC curve or the 9-day MA.

As per this statistics the key reversal turns out to be not predictive of a trend switch.
Let us see if it still may be an actionable trade signal.

In the same statistical sample as described above:

1) The probability of the next day Low being lower than the DKR.Close has been
85.5%
2) The next day Low < 0.99* DKR.Close (i.e. a Low at least 1% lower than
DKR.Close) would occur with probability 66%
3) The probability of the next day Low < 0.98*DKR.Close has been 40% .

It might seem from this that the strategy of shorting stock near DKR.Close and then
covering for 1% profit the next day would have 2:1 odds of success. Unfortunately, the
problem lies in the remaining 34% of cases, where the key question is: when to cover?
If we add the cover near close if not covered yet rule, then a quick back test tallies the
overall strategy at a token loss of 0.05%. Arguably, the loss is at noise level and the
strategy is profit-neutral

To make this line of trading profitable, one has to enter the short position above
DKR.Close and/or maintain the position for multiple days to meet a profit target.
But this has us looking for additional signals, which is outside the scope of this essay.
References.
[1] http://store.activetradermag.com/index.asp?
PageAction=VIEWPROD&ProdID=1009 (Retrieved on Aug 8, 2008.)

[2] C. Brown. Technical Analysis for the Trading Professional, McGraw-Hill, 1999

[3] http://www.incrediblecharts.com/technical/key_reversal.php , Retrieved on Aug 8,

2008.

[4] http://www.spectrumcommodities.com/education/tech/c.html Retrieved on Aug 8,

2008.