Three scanners to find potential reversals

Falling markets are simple to trade. I guess due to high volatility it becomes easy to enter and exit at a much faster pace. Once the trend is established, all we need to do is find an underperformer and with simple validation on price, volume or open interest we just need to initiate.

Problem comes when the indices start consolidating at lower levels after a fall. Bigger question here is that is this just a halt before further fall or a reversal point. Also, these consolidations do not happen because nothing is moving. Instead, they happen because some are falling at a fast pace, and some are rising also at a good pace.

Here we need few scanners to see if the stock with small bit of strength today is set up for a potential reversal or is it just a short-lived recovery.

Scanner #1: Price

The biggest testimony to any potential move is the strength in its price action. Be this a down or up move, the stock has to be in a price move that supports the direction. In our case, we already have a stock that is up for the day.

Scanning it is necessary for the recent past. For a reversal if not more then at least for the last 10-15 days we need to apply price scanner. The characteristic we are looking for is the outperformance. The stock may not be up from 10 days before price but at least when compared to Nifty it should have fallen less.

Scanner #2: Open Interest

Open interest is defined as “the number of contracts or commitments outstanding in futures and options that are trading on an official exchange at any one time.” Simply put, it is the number of positions open in any contract.

Rising open interest with rise in price is looked at as a bullish incremental position. Rising open interest with fall in price is looked at as a bearish increase in positions.

Scanner here is that in last few days including the day of trade, we need to have bullish increment in positions. So, the outperformance in the Price needs to have backing of increase in open interest. This open interest must be bullish incremental positions.

Scanner #3: Implied Volatility

Implied Volatility is defined as the volatility input implied by the option premium. Calculation of option premium has volatility as one of its inputs. For given market price of option premium, we can back calculate such volatility input. This back calculated volatility is called implied volatility.

Implied volatility or IV is more of a forward-looking feature. It is expected volatility. Since falls are faster and rise in slower. Falling IV means there is expectation of a rise and rising IV means expectation of a fall.

When we have both of the 2 scanners cleared, last scanner is IV. Here we see at least from a weekly perspective we are at least a tad bit lower in IV than last week’s reading.

If these 3 scanners go thru, we would have raised the odds of a reversal in that stock. Lastly, both IV and Open Interest is available on many analytical platforms including exchange websites for use to observe.