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Thomas Bulkowski’s successful investment activities allowed him to retire at age 36. He is an internationally known author and trader with 30+ years of stock market experience and widely regarded as a leading expert on chart patterns. He may be reached at

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Bulkowski's Key Reversal, Downtrend

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There are more than one pattern called a key reversal. Here is one implementation.

The Key reversal pattern
Key Reversal, Downtrend

 

Important Bull Market Results for Key Reversal

Overall performance rank (1 is best)**: 3/23
Break even failure rate*: 43% (Up breakouts)
Average rise*: 7%
Percentage meeting price target*: 69%
 
The above numbers are based on hundreds of perfect trades as of 3/12/2013. See the glossary for definitions.
* Based on the trend high, not the ultimate high. See text.
** Based on the average rise compared to other small patterns with upward breakouts in a bull market

Key Reversal, Downtrend, Identification Guidelines

CharacteristicDiscussion
2 barsThe pattern is composed of two bars.
DowntrendLook for the pattern in a short-term downtrend.
Outside dayThe pattern forms an outside day. In this case, look for today's close above the prior day's high, today's open below the prior day's close, and today's low is below the prior day's low.

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Key Reversal, Downtrend, Trading Tips

Trading TacticExplanation
ReversalThe pattern is supposed to act as a reversal of the downtrend. However, testing shows that 51% actually continue lower.
TradeTrade in the breakout direction. A breakout occurs when price closes either above the top or below the bottom of the pattern.
Measure ruleThe key reversal fulfills the measure rule 69% of the time (bull market, up breakout). That is, measure the height of the pattern and subtract it from the low price to get a downward target. For upward targets, add the height to the price of the top of the pattern.

Key Reversal, Downtrend, Performance Statistics

For the following statistics, I used 1,189 stocks, starting from January 1990 to March 2013, but few stocks covered the entire range. All stocks had a minimum price of $5. There were two bear markets in the 2000s (as determined by the S&P 500 index), from 3/24/2000 to 10/10/2002 and 10/12/2007 to 3/6/2009. Everything outside of those dates represents a bull market.

For each downtrend key reversal, I found when the trend started and when it ended. To find the trend peak or valley, I found the lowest valley and highest peak within plus or minus 10 days (21 days total) each, before the key reversal and the same peak/valley test after the key reversal. The closest valley or peak before the key reversal is where the trend began. The closest peak or valley after the key reversal is where the trend ended. I compared the peak or valley to the average of the highest high and lowest low price of the key reversal pattern.

The 10-bar peak or valley number tends to find major turning points on the daily charts.

I measured performance from the opening price the day after price closed either above the top or below the bottom of the pattern to the nearest trend peak or trend valley.

To determine the inbound price trend (I was looking for a down trend), I used linear regression on the average of the high-low prices in the five days before the pattern. That caught the short-term trend.

Key Reversal, Downtrend, Performance and Failure Rates

Table 1: Performance and Failure Rates
Market/Breakout direction 5% Failure  Average 
 Rise/Drop 
Bull market, up breakout43%7%
Bull market, down breakout50%-7%
Bear market, up breakout35%9%
Bear market, down breakout29%-12%

Table 1 lists the failure rates, sorted by market condition along with the average rise or drop. Although the key reversal is supposed to act as a reversal of the downward trend, I did not make that assumption. Instead, a trade occurred at the open the day after price closed above the top or below the bottom of the key reversal.

A failure occurs when the stock fails to move more than 5% in the breakout direction.

The failure rates may appear high, but that's typical for short-term patterns like the key reversal. The highest failures occur in a bull market.

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Key Reversal, Downtrend, Measure Rule

Table 2: Measure Rule Performance
Market/Breakout direction Success 
Bull market, up breakout69%
Bull market, down breakout61%
Bear market, up breakout60%
Bear market, down breakout64%

Table 2 shows how often the measure rule works. Use the measure rule to estimate of how far price is likely to move.

To do this, measure from the highest high to the lowest low in the pattern to get the height. Subtract the height from the lowest low or add it to the highest high to get the down/up target.

The best performance of the measure rule occurs when the breakout direction follows the market trend (bull market, up breakout or bear market, down breakout). Trade with the trend.

Key Reversal, Downtrend, Trading Performance

Table 3: Testing the key Reversal, Downtrend
Market/Breakout direction Bull/Up  Bull/Down  Bear/Up  Bear/down 
Net profit/loss$95.28$(88.09)$(81.33)$42.84
Wins58%43%46%52%
Winning trades3,930986899444
Average gain of winners$702.75$743.74$721.01$765.49
Losses42%57%54%48%
Losing trades2,8471,3121,066414
Average loss($743.27)($713.23)($757.98)($732.17)
Average hold time (calendar days)28251612

Table 3 shows the performance based on 11,985 trades using $10 commissions per trade ($20 round trip), starting with $10,000 per trade. No other adjustments were made for interest, fees, slippage and so on.

The results are sorted by bull or bear market, up and down breakouts. The trades used the same setup as listed in Key Reversal, Downtrend, Performance Statistics.

Here's the setup.

  • Find a downtrend key reversal
  • Wait for price to close either above the top or below the bottom of the key reversal.
  • Buy (up breakouts) or sell short (down breakouts) at the open the next day.
  • Close out the trade when price moves 7% in the breakout direction.
  • A stop placed 7% opposite the breakout direction also closes out the trade for a loss.

For example, in a bull market, the net gain was $95.28 for all trades. The method won 58% of the time and there were 3,930 winning trades. The average gain of winning trades was $702.75.

Forty-two percent, or 2,847 trades were losers. They lost an average of $743.27.

The average hold time was 28 calendar days.

Notice how the gains and losses were pegged near 7%, which is how the test was setup.

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Key Reversal, Downtrend, Trading Example

Key reversal in 3M (MMM)

The figure shows a key reversal pattern in 3M (MMM) on the daily scale, shown in the inset.

Price drops leading to the key reversal. Then an outside day appears (which is the key reversal). On the second day of that pattern, price opens below the prior close and closes above the prior high. It's an outside day that stages a lower low.

This downtrend key reversal acts as a reversal of the short-term downtrend.

At A, the stock stages an upward breakout when it closes above the key reversal. At B, the trade begins at the open. Price rises 7% to the target at C, where it's sold.

If the stock turned down, sell 7% below the buy price.

-- Thomas Bulkowski

 

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See Also

Below are other short patterns...

Written by and copyright © 2005-2017 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. An ostrich's eye is bigger than its brain.