As the name suggests, a reversal is an indication that price may quickly change direction. The reversal is most commonly seen as a combination of two bars, although it may also be seen as a multi bar combination.
The reversal is known by many names, and can be used in either direction of a trend. In a generic form it is best known as a 'Reversal', a 'Key Reversal', or a 'Two Bar Reversal'. In a potentially bullish form they can be known as a 'Bullish Reversal', a 'Bottom Reversal' or even as part of a 'Selling Climax'. And as a potentially bearish combination, the reversal may be known as a 'Bearish Reversal', a 'Top Reversal', or as part of a 'Buying Climax'.
A reversal can be a major event and prove to be part of a major pivot, or a less serious event or minor pivot. The amount of volume, relative to the previous recent volumes, will usually offer some indication of the overall strength of the reversal at the time. Very high volume (or value traded), particularly on the first bar, may indicate a more serious event. Also remember that if the reversal takes place in an already vulnerable market (one with serious selling already in the recent background, for example), the new trend that develops may become a self fulfilling action, and become more serious than the initial reversal suggested.
The spread , or range, of a any bar can be considered an indication of volatility. So a narrow spread shows a lack of volatility, and a wider spread indicates increased volatility. A volatile market can also suggest a level of instability.
When seen, the spread or range, of a reversal will generally be increased over previous recent bars, and will almost always be average to wide. So it may be that the recent trading has seen relatively narrow spreads, and the reversal takes place with only an average spread (but increased over previous trading), or the reversal may take place with a wide spread. Note that both forms show an increase in spread (or volatility) over previous recent trading.
The reversal can be a standard buying or selling event, or as an engineered construct to accumulate or distribute stock, for whatever reason (as an example, to buy or sell stock in a tight market, without moving price too much).
The most common and text book form, is a two bar combination (they can also be multi bar combinations - where it is usually the second bar that is broken up into more than one bar). Consider this example of a potentially bullish reversal, one that will form a low pivot (see above). The first bar will have an increased spread over previous bars, it will thrust lower and usually close at (or near) the low of the bar, and see an increase in volume. The second bar may initially dip a little below the first bars low (but not always), before price completely reverses direction, and eventually closes beyond the initial bars high. At this point it is a 'potentially' bullish reversal. To become a 'successful' reversal, the subsequent bars will continue higher in response.
Now breaking this combination down further to understand more about what is actually happening.
The initial bar is some form of climactic action (the timeframe and volume will indicate how powerful). The close of the first bar right down at the low of the bar (in this potentially bullish example) infers impending and continuing weakness to existing holders. This is usually engineered to encourage vulnerable holders to sell their position in fear of losing more value in the future. At this point it is quite difficult to know for sure, that the first half of a reversal has taken place (that is the idea, otherwise it would not work properly). The increased spread, close at the extremity and excessive or increased volume, are the only tell tale signs at this stage.
-- now also consider at this stage (after the first wide spread downbar), that some holders may be more inclined to sell than they were before this nasty event has taken place, but they may hope for a higher price than is now available, so instead of selling 'at market' they place their stock for sale on the 'offer', at a higher price than is currently available (and hope price comes up to hit it) --
So the second bar now begins. It will sometimes (but not always) initially dip below the first bars low, to test for any further supply (selling) in the form of a mini shakeout. Then it begins to reverse, slowly grinding higher, buying the new stock that has been placed on the 'offer'. The textbook form will see price eventually close above the first bars high, although if the 'offer' becomes really strong (which actually suggests the first bar did not work as well as it could have....), it may take another period or two to buy it all. The key thing at this point is that it is only an 'attempted' reversal until price closes above the first bars high (and even then it is a 'potential' reversal, until subsequent up bars prove it to be successful). The close above the first bars high is a strong indication that a reversal has taken place, and it is not some other form of price action.
I generally prefer to see much higher volume on the first bar, and much lighter volume on the second bar. As this shows that price was thrust lower to shakeout stock, and catch stops on the first bar. And if done really well there will not be very much stock now available within the spread or range of this bar, leaving a temporary 'supply vacuum' in its place (because all the stock that 'was' for sale at this level has now been bought). This then allows price to easily reverse on the second bar, as there are not many sellers at this level, and only a relatively small amount of trading (volume) can now push price higher (and that is why price can easily close above the first bars high, and indicating a potential reversal).
Sometimes volumes will be the other way around, with lower volume initially, and higher volume on the second bar. This suggests that on the initial bar selling pressure was low and the main trading was done on the second bar.
To my way of thinking, this shows that the first variety was engineered to surprise the market and was able to successfully shakeout stock, leaving a supply vacuum for the second bar. Whereas the second form may have developed naturally (without intent), or as a construct in a very tight market to gain whatever stock is available when the 'offer' is reloaded after the initial push lower (a form of desperation, perhaps to help cover a short position in a rising market, without pushing price against their position etc).
When this second variety is seen in an uptrend and in a market with tight supply, take note, as price is likely to continue rising in the future.
I have used a potentially bullish example all the way through, and the potentially bearish reversal is the exact mirror image opposite (see above). The first bar thrusts higher, enticing the market to jump on the momentum (it's going to the moon.....). The high close is a cause for strong optimism in the market. Volume and spread are increased, to high and wide. The second bar may see a brief push higher (to sell or position short into the remaining demand) before price reverses and begins sliding lower (easily because there are now few buyers in a 'demand vacuum'). Then the falling market sees selling emerge, which only helps push price lower. The close below the first bars low suggests a bearish reversal has taken place, and a number of downbars in response, or a subsequent downtrend, confirms it as successful.
Finally a few other notes, a reversal like this, once confirmed, is a relatively safe position for stops to be placed behind, as there is usually support or resistance surrounding a structure like this.
The bullish reversal can be quite a powerful combination, whether is be at a high or low pivot, or in a trending market. When seen and confirmed, the construct will not go away, so if price comes back to test its strength, as soon as some confirming trading arrives that allows an entry, position in the direction of the reversal, and you will be right more often than wrong.
The basic rules for a reversal like this can roughly be used for any two bar arrangement. It may not be an actual reversal, but it will usually work for at least a bar or two in response -- as an example the XJO had one this week, it wasn't really a 'proper' reversal, but has worked so far (as friday's bar was up) see below.
