Using the RSI to help pick short entry and exit points

The Candlestick Trading Bible

Candlestick Trading for Maximum Profits

Get Instant Access

You can combine the RSI with your candlestick patterns to pick wise entry points for a short trade. But that's not the whole story. You can also use that same combination of trading tools to indicate when you should exit a short.

Figure 13-3 presents a situation in which a combination of the RSI and a bearish candlestick pattern can show you when to get in and out of a short position. The chart is for Peabody Energy (BTU), a mining company that focuses on coal production.

Peabody Energy's symbol may seem a little odd at first, but BTU stands for British Thermal Unit, which is a measure of the heat value of various fuels. Makes sense for a coal producer, right?

Figure 13-3:

A chart of BTU where a combination of the RSI and candlesticks indicate a short entry and exit point.

Figure 13-3:

A chart of BTU where a combination of the RSI and candlesticks indicate a short entry and exit point.

Entry And Exit Candlestick Patterns

The bearish candlestick pattern in Figure 13-3 starts to develop after several up days in a row. Along with this strength in the stock's price, the RSI rises to a level over 70 (overbought). The three outside down pattern then appears, with a black candle on the second day that's an outside day relative to the first day. The pattern is completed with a down day on the third day. (To understand the inner workings of the three outside down pattern, check out Chapter 10.) The uptrend is reversing to a downtrend, so the time is right for entering a short.

There's another element to the chart in Figure 13-3 that's worth highlighting. The three outside down pattern is completed when the RSI level is just a hair over 70. Seeing the RSI in an overbought range when a reversal pattern is completed is pretty rare, because a reversal pattern normally occurs when a trend changes direction, and when that happens, the RSI usually ends up in the middle range between overbought and oversold.

The exit level for this short isn't set in stone, but it should definitely yield a profit on the trade. The RSI moves down below 50 fairly quickly with the downtrend, and that should serve as a signal to start keeping an eye out for some sort of exit pattern or reversal in the downtrend. Unfortunately, another reversal pattern doesn't come along to tell you when to exit the short. But that doesn't mean that you have to just take a stab in the dark to figure out when to get out. There's a period of four days where the downtrend appears to be in trouble; the trend flattens and a couple of bullish days pop up. You can decide at that point that the trend has run its course, and it's time to get out and take a profit. You can enjoy even larger profits if you hold on just a little while longer, because the downtrend kicks back in and the stock trades lower still. But you have to exit the position sometime, and a good opportunity for that comes when the RSI pushes below the oversold level. Even without a pattern to confirm it, that should serve as a pretty solid sign that it's time to exit and book your profits.

I provide one more example of how you can use the RSI in tandem with bearish candlestick patterns to flesh out short entries and exits for short trades in Figure 13-4. This chart is of Radio Shack (RSH), which is an electronics retailer that covers the U.S. with more than 1,000 stores.

The RSH stock in Figure 13-4 is in a well-defined uptrend with the RSI reaching just a tad over 70. The day that the RSI reaches 70 is also the first day of a three outside down pattern (see Chapter 10 for details), and that serves as a signal for you to enter into a short trade.

If you short after seeing this combination of an overbought RSI and a bearish reversal candlestick pattern, you're quickly rewarded with a gap down on the opening of the day after the pattern is completed. You may shudder a bit two days later when there's a gap up and the high of the pattern (a resistance level) is approached, but that level isn't violated and the signal remains valid. The stock continues to trade off, and during this downtrend the RSI works its way down to below 50. Here is where you should start watching out for an exit point.

The exit signal in Figure 13-4 comes quickly, with a one-day reversal pattern. With the downtrend in place and the RSI in the bottom half of its range, a hammer day appears. (You can read all about the hammer pattern in Chapter 6.) The signal is a reversal pattern, and determining the trend that follows the pattern generally depends on the market context in which the pattern appears. The prevailing trend is clearly down in this situation, so you can bet that the hammer indicates that a switch to an uptrend is in the works. That turns out to be just the case, and the stock starts trading higher.

Figure 13-4:

A chart of RSH where the RSI and two bearish candlestick patterns tip you off on the best entry and exit points for shorting.

Figure 13-4:

A chart of RSH where the RSI and two bearish candlestick patterns tip you off on the best entry and exit points for shorting.

The hammer pattern serves as a useful short exit signal in Figure 13-4, but the profits on the trade weren't exorbitant. However, you still earned some revenue, and by using the candlestick pattern for an exit signal you avoided seeing your earnings winnowed down (or even turned into losses) as the trend heads upward for a stretch.

Using the Stochastic Indicator and Bearish Candlestick Patterns for Shorting

If you're interested in another reliable technical indicator that you can combine with bearish candlestick patterns to help you in your short trades, look no farther than the stochastic indicator. The stochastic indicator can be a very useful trading tool when you're trying to determine when a security is overbought or oversold. You can read all about the stochastic indicator in Chapter 11, but for this discussion just keep in mind the following points:

^ The stochastic indicator includes two components: the fast and slow stochastic.

^ The fast and slow stochastics oscillate between 0 and 100.

^ When the fast stochastic is under the slow stochastic, there's a downtrend in place.

^ When the fast stochastic is above the slow stochastic, there's an uptrend in place.

^ The stochastic indicator can be based on a variety of look back periods. In this chapter my examples have a 14-period look back, which you'll find is a standard level in charting packages.

^ Overbought and oversold levels on the stochastic indicator can vary, but in this chapter I use the standard levels of 20 for oversold and 80 for overbought. Keep in mind that this is slightly different than the standard oversold and overbought levels used for the RSI.

This section focuses on how to use the stochastic indicator alongside your candlesticks in shorting situations. Keep in mind, though, that you can use the same information to help you figure out when to get out of a long position. The rule is fairly simple. If you have a long position and the trend looks like it's going to head downward, exit and book your profit!

Was this article helpful?

0 0

Post a comment