Using the RSI to help pick long exits

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An additional benefit to using technical indicators for determining entry points is that they may also help you figure out when it's time to exit a position. When used properly for entries, an indicator tells you when to buy an oversold security or sell short when a security's price reaches an overbought level. You can take advantage of that same concept when deciding when to exit trades.

For example, suppose you took a long position on a stock when you saw that its RSI was oversold, and as a result you're sitting on what could turn out to be a handsome profit. But then the RSI changes course, and soon it's into the overbought level. What should you do? You may have a trading rule in place that tells you that it's time to exit the trade without considering other options. But you may also take a slightly more liberal tack and simply keep a close eye out for trend breaks or reversal patterns. You can play out the situation in several ways, and if you can combine the technical indicator with your knowledge of candlestick patterns, you stand a much better chance of exiting the trade at the most opportune moment.

For short-term long trades involving the RSI, I begin to look for an exit point when the RSI trades over 50. Until that level is reached, I stick to the stop level prescribed by the candlestick pattern I used to enter the trade. After the RSI reaches 50, I start to watch for a reversal or trend break. You may think that I'm potentially leaving too much profit on the table, but just because a stock has traded higher and the RSI is above 50 doesn't mean I'm out. It just means I'm more cautious if I think things are going to turn. Consider a similar strategy for yourself.

For an idea of how you can combine candlestick patterns with the RSI to figure out when to enter and exit a trade, look at Figure 12-3 — a chart of the oil and gas exploration company Devon Energy (DVN). As you can see, the stock trades off pretty hard, and the RSI is well under 30. Then around the time that the RSI trades back up to about 50, a bullish reversal pattern appears. It's the three outside up pattern, and you can read all about it in Chapter 9.

Figure 12-3:

Using the RSI and a candlestick pattern to select an entry and exit on a chart of DVN.

Figure 12-3:

Using the RSI and a candlestick pattern to select an entry and exit on a chart of DVN.

If I were trading the scenario you see in Figure 12-3, I'd place a stop loss order based on the low of the candlestick pattern and keep that stop in place until the RSI crosses above 50. That way I'd still be in the trade even if a small pullback occurred. After the RSI reached 50, I'd simply keep an eye on the trend. The trend eventually heads higher with a clearly defined trend break, and when that trend break occurs, I'd execute a sell order and pocket a nice profit. I know that it looks quite easy in hindsight, but it really is a prime example of how you can use the RSI in conjunction with candlestick patterns, particularly bullish reversal patterns.

Still not convinced? I offer another example in Figure 12-4. That figure features a chart of Texas Instruments, which is a technology and semiconductor company that trades under the symbol TXN. You can see that the ideal entry point is when the RSI has been under 30, and then a three outside up pattern appears which indicates that the trend is headed upward, and you need to buy and take on a long position.

After a promising start, the stock stalls out and things look a bit disappointing. The trading is essentially trendless for a couple of weeks. The support level isn't broken, and an uptrend doesn't develop. If you stay patient, though, eventually you see the stock make a small run. The RSI gets back up to 50, and then on the following day, a hanging man pattern appears. (Flip back to Chapter 6 for more on the hanging man.) That's a reversal signal, which indicates that the trend is heading southward, and the time has come to sell the stock, enjoy a small profit, and move on to the next trade.

Figure 12-4:

Combining the RSI and candlesticks to select an entry and exit on a chart of TXN.

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