The key to successful trading lies not in specific indicators, but rather in when, how, and where they are used. Indicators are nothing more than tools… and no single tool will accomplish every task you encounter.

You have probably encountered many approaches to trading and a plethora of indicators. Most innovations are nothing more than a twist on an old indicator. Many old indicators are also nothing new — just a different way to describe a ubiquitous principle. This is why a master like W.D. Gann frequently quoted Solomon from almost 3,000 years prior: “There is nothing new under the sun.”

True discovery usually lies in re-discovery. Many revolutionary discoveries are made by simply ‘tweek’-ing an old invention, or approaching a problem from a different angle. There is still a great deal to be learned from some of the oldest and best-known technical price patterns… like the key-reversal.

Key Point – The basic key reversal pattern.

Some readers may be convinced that a key-reversal is an over-rated and unreliable price pattern. In its original state, and by itself, this may be true. More likely, however, is that traders expect too much from this signal, have no means of filtering it, and do not understand when its application is complete.

This is what is explained in the following 3 examples of my Tech Tips. This is just one of nearly two dozen examples of how useless indicators have received a breath of new life into them or how over 25 years of trading and research spurred the development of new tools. But back to the example of key reversals…

A key-reversal is any price tick which contains a new high (above the previous tick’s high) and lower close… or a new low and higher close (see illustration) [NOTE: For the purpose of the remaining discussion, a down-ward daily reversal from a prevailing uptrend — a new daily high and lower close — will be assumed in all examples. The principles discussed apply to all reversals, and all time frames, whether up or down.]

A key-reversal is not intended to signal a major turning point. It only indicates that short-term momentum has changed. If it is not quickly confirmed, a key reversal becomes powerless! A key-reversal does reveal some important considerations. The fact that the prevailing trend initially followed through from the previous period (causing the new high or low), but then was able to reverse and close in the opposite direction — says something significant about the prevailing sentiment.

The question is how long will this new sentiment dominate? This question begins to address the biggest problem that most traders have with indicators… overrating their effectiveness and applicability. The secret to consistent profits lies in knowing when to use (or when not to use) an indicator — and for how long

Based on 25+ years of experience and observation, it has become obvious that most reversal patterns are only applicable for the next 1-3 periods.

If the pattern in question is a daily key reversal, it should have an impact for the ensuing 1-3 days… and no more. If the pattern is a weekly key reversal, it is applicable for the following 1-3 weeks… and no more.

This does not mean that the new trend (spurred by the key reversal) will terminate after three periods. Nor does it mean that a key reversal can not occur at a major top or bottom. What it does mean is that a secondary indicator must confirm by the end of that period — in order to prolong the current move. If this occurs, then the new signal will spur an additional 1-3 periods of movement, or more.

Trading any given trend is like a road trip which begins in familiar territory with frequent stops and starts. As the trip (trend) progresses, the goal is to get to the freeway (main trend) and experience some ‘clear-sailing’. Ultimately, the freeway/main trend is exited and the stops and starts begin again until the final destiny (major top or bottom) is reached.

In the same way that a driver does not assume that every turn in city traffic is going to lead to clear sailing, a trader should not assume that every reversal is the final high or low. Only two (out of literally dozens, or even hundreds) can be THE top and THE bottom.

What does this mean? It should demonstrate how and where reversal patterns fit into an overall trading strategy… and into an overall trend. They are not indicators of the overall trend, whether or not it is a new or existing trend. They are indicative of very small trends within a larger period of consolidation. Eventually, one of these will place you on the on-ramp to a break-away move… but only one!

So, do not trade a key reversal (in any of the following forms) as if it is the main trend… and do not drive on city streets as if they are the freeway. Harsh monetary penalties are reserved for both of these infractions. With that groundwork laid, it is time to discuss the three most effective types of key reversals. They are:

  1. Double-Key Reversal
  2. Turn-Key Reversal
  3. 2-Close Reversal