Many traders use the overbought or oversold levels in the market in their trading decisions. Overbought means that there are more buyers in the market than sellers. So the market is bullish. On the other hand, oversold level means that there are more sellers in the market and the market is bearish. One of the most popular indicator that is used to determine the overbought or oversold levels in the market is the Relative Strength Index (RSI) indicator. RSI values range between 0 and 100. When the RSI reading is below 30, it means that the market is oversold and when it’s reading is more than 70, it is an indication that the market is overbought.
The good thing is that you can combine RSI reading with candlestick reversal patterns to further confirm that a reversal is imminent and you can take a long position. You can also use the RSI to select your exit level.
Let’s take an example to make it more clear. Suppsoe you want to trade a stock. You are using RSI indicator to determine when the market is oversold. You wait for sometime and ultimately find RSI reading to be less than 30 meaning that the market is now oversold and you can enter your trade. But a better way would be to wait for the bullish candlestick reversal pattern to appear. So you sopt one, the famous Three Inside Up Candlestick Reversal Pattern. This candlestick pattern usually appears when the market is about to turn bullish after many bearish days. Now when you spot such a candlestick reversal pattern, it is a confirmation that the market is indeed oversold and is about to turn bullish. This is the right time to enter the market just at the level where the candlestick reversal pattern appeared.
The good thing about the three inside up reversal pattern is that it takes three days to form. When you see this pattern on the first two days, wait for the third day candle for confirmation tha the pattern is indeed the three inside up candlestick reversal pattern. On the first day, you will find a bearish candle followed on the second day with a bullish candle with a small body. When you spot this pattern, you should get ready for the third day candle to be bullish and bigger than the second day to confirm that this is indeed the bullish three inside up candlestick pattern. So three days give you plenty of time to observe the market and confirm that the market is indeed turning bullish from bearish and the trend is about to reverse itself.
Now, when the three inside up candlestick pattern appears, it is an indication that the market has indeed turned bullish and you are about to see a bullish market for many days. This means that the market has reversed and a new uptrend has started. This is the best time to go long on the stock. Place the stop loss close to the position where you went long as the market is not supposed to return to that level for many days. As long as the RSI reading is below 70, you can rest and relax. But don’t wait for the RSI reading to go above 70, get alert when the RSI reading goes above 50. This is an indication that the market is above to become overbought and you should start looking for a candlestick reversal pattern to appear to confirm this.
When you find the candlestick reversal pattern like the bearish three outside up candlestick reversal pattern, this is the confirmation that the market is indeed turning bearish now. This is the time to take profit and exit the market. Combining RSI or Stochastic Indicator with Candlestick Reversal Patterns can be powerful tool in your trading arsenal.
Mr. Ahmad Hassam has done Masters from Harvard. Get the Ultimate Swing Trading Software FREE. Get these three great Stock Trading Reports written by battle hardened investing professionals FREE.
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This post was written by MoMoney on January 24, 2010
