Picking short entry points

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Picking the best entry point for a short can be a difficult undertaking, but using the stochastic indicator as a supplement to your candlestick patterns can make the task much easier. For a prime example of how the stochastic indicator can be used with a bearish candlestick pattern to pick a short entry, take a look at Figure 13-5.

In the figure, you see a chart of Convergys Corporation (CVG), a provider of specialized software solutions for business customers. Its headquarters is in Cincinnati, Ohio, and Cincinnati's airport code is CVG. Coincidence? Nah, probably not. As you can see, the stock's price action is pretty bullish for a few days, and the result is a stochastic indicator reading over 80. The three inside down candlestick pattern forms shortly after the indicators reach this overbought level. Feel free to flip back to Chapter 10 for more information on the three inside down candlestick pattern.

The situation is ripe for a short entry, and the short entry situation gets even better when the fast stochastic crosses under the slow stochastic while both are still in overbought territory. If you see that combination of factors come together, you should be quick to enter a short position, because all signs point to a forthcoming downtrend.

For a second example, see the chart of Xerox (XRX) stock in Figure 13-6. Xerox has become synonymous with document solutions for all businesses great and small.

Figure 13-5:

A bearish candlestick pattern and the stochastic indicator reveal a short entry on a chart of CVG.

Figure 13-5:

A bearish candlestick pattern and the stochastic indicator reveal a short entry on a chart of CVG.

Figure 13-6:

Short entry points are signaled by bearish candlestick patterns and the stochastic indicator on a chart of XRX.

Figure 13-6:

Short entry points are signaled by bearish candlestick patterns and the stochastic indicator on a chart of XRX.

Candlestick Patterns With Stochastic

In the middle of the chart in Figure 13-6, I highlight three points where the stochastic reading is overbought. Two of those points are accompanied by bearish candlestick patterns, and one isn't. Guess which ones provide the best entry point signals? I explain each scenario:

I The first of the three points at which the stochastic indicates that the stock is overbought occurs as the stochastic indicator comes to the end of an uptrend that was in place for a few weeks. The overbought level is reached just when a hanging man (a bearish reversal signal covered in Chapter 6) appears on the chart. On the very next day, the fast stochastic crosses under the slow stochastic, which signals a short entry point and a confirmation of the hammer pattern as a reversal signal.

Initiating a trade on this day, can prove profitable. Bearish activity prevails for a few days after the signal, but it's not the significant downtrend a short seller would hope for. Still, though, it can result in a profitable trade.

i The second of the three points comes when the stochastic indicator rebounds into overbought territory. The indicator almost provides some signals, but nothing really comes of it for a few days. Finally, the indicator appears to signal a short entry opportunity, but as you can see, there isn't a corresponding bearish candlestick pattern.

If you rely solely on the stochastic indicator in this situation and initiate a short position, you'll be sorry. The downtrend promised by the stochastic indicator doesn't appear, and the stock continues to trade higher. Ouch!

I The last and best of the three signals occurs after the trend has continued upward and the stochastic readings have reached an overbought level yet again. This time, though, the three outside down pattern (see Chapter 10 for more details) emerges, and during the pattern's formation the fast stochastic crosses under the slow one. A downtrend is probably on the way, and entering into a short position is smart at this time. Then you'd be rewarded handsomely, because the stock trades off heavily for quite some time and the potential profit is quite attractive.

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