Picking short entry points with the RSI and candlesticks

When using the RSI combined with a candlestick pattern to pick a good time to enter a short position, you want to see an RSI reading over 70 (or your personal overbought level) that coincides with the formation of a bearish candlestick pattern. If you have your eye on a chart and you see those two things come together, get your short pants on! (That's just a figure of speech, of course — I encourage everyone to wear pants of an appropriate length while trading.)

What better way to master these scenarios than to see them on a chart, so please take a gander at Figure 13-1. This example is a situation when you can combine the RSI with a bearish reversal candlestick pattern to figure out when to put on a short. The chart in Figure 13-1 is of the stock for Masco (MAS), a manufacturer and distributor of home improvement and building products. With fundamental exposure like that, it's an excellent stock to trade when the economic outlook is in question.

The RSI in Figure 13-1 goes into the overbought range early in November, and when you see that happen, start looking for bearish reversal candlestick patterns. In this example, the pattern comes in the form of a gravestone doji. (Check out Chapter 5 for the gravestone doji details.) The gravestone doji can indicate a reversal in either direction, but in this case there's an established uptrend, and the RSI reading has been overbought for some time, so it's very safe to say that this particular gravestone doji is signaling a bearish reversal.

Figure 13-1:

An overbought RSI reading and a doji reversal pattern signal when to initiate a short on a chart of MAS.

Figure 13-1:

An overbought RSI reading and a doji reversal pattern signal when to initiate a short on a chart of MAS.

If you keep an eye on this overbought RSI and you spot the gravestone doji, you'd put on a short position, because the gravestone doji really shows that the bears are taking control of the price action after a run by the bulls. The pattern is followed by a small downtrend that lasts just a couple of weeks. You wouldn't be able to go out and start shopping for yachts if you trade this pattern successfully, but it's certainly worth studying, because it's a fairly reliable indication of bearishness.

Perhaps it's most important to note that this example shows you how the RSI (or other technical indicators, for that matter) can be very useful when you spot a reversal signal that doesn't tell you definitively which way the trend will go. You've got to really be sure of the market environment in those cases, and the RSI can tell you what you need to know.

Good things do come in pairs, so I provide another example of how you can combine the RSI with a bearish candlestick pattern in Figure 13-2. This figure features a chart of the futures contracts that trade based on the level of U.S. Treasury bonds.

You can see in Figure 13-2 that the price action produces a three inside down pattern, which is a pretty reliable bearish reversal pattern that I describe in detail in Chapter 10. The pattern's first day is a white candle that occurs in an uptrend. More importantly, this first day combined with the price action leading up to it causes the RSI reading to close over 70, which tells you that you're looking at an overbought situation. The pattern is complete with a bearish second day that's inside the first day, and a down final day.

Figure 13-2:

Treasury bond futures with the RSI and a bearish candlestick pattern signaling a useful short position entry.

Figure 13-2:

Treasury bond futures with the RSI and a bearish candlestick pattern signaling a useful short position entry.

Candlestick Patterns Entry Exit

If you want to capitalize on a situation like this, enter a short sale near the completion of the pattern or be prepared to put on a short on any small rebound during the next couple of days. The combination of the candlestick pattern and the overbought level of the RSI turns out to be a solid sell signal. The price action following the end of the pattern results in a quick drop of over three points in the Treasury bond futures. Although three points may not sound like a lot, consider that a point move in a single contract is worth $1,000 (when you're on the right side).

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