Chart 7 -The standard oscillators in Stockcharts.com can be overlaid on the centered detrend (or on top of prices) in the search for an oscillator that tops and bottoms as the trading cycles top and bottom. Not surprisingly, the performance of these oscillators for identifying trading cycle tops and bottoms can be improved by a few simple techniques.
To use an oscillator to identify cycle tops and bottoms look for three characteristics:
1. The oscillator turns when prices turn
2. The oscillator does not "wiggle" much at cycle tops and bottoms
3. The oscillator has amplitude moves that take it to the extremes of an
allowable range as the cycles bottom and top.
One such oscillator is the Wilder RSI. If the RSI 3 is used it provides frequent enough oscillation to fit a swing trader's needs. A smoothed RSI with a 3 bar averge is best (RSI3M3). It shows the bottoms and tops of the trading cycle almost as well as the centered detrend and can be used as a mechanical trading signal and cycle identifier… And the RSI3M3 is current to the most recent price bar, turning down in this chart to identify the most recent trading cycle top (not normally identified by the centered detrend (DPO)).
OSCILLATOR/PRICE PATTERNS GENERATED
Chart 7 - The RSI3M3 oscillator is current to the most recent price bar and shows cycle tops and
bottoms as well as the centered detrend.
NOTE: Many use the RSI without understanding its relationship to cycles. By using 20/80 lines we may miss some trades that could be taken if we used 30/70 lines. Still we caught good entries at 1, 3, 5, and 7. We got good exits at 2, 4, 6 and 8. Using 20/80 or 30/70 is an individual decision (20/80 is a more conserative approach).
MECHANICAL TRADING SIGNALS
Chart 8 - There are four steps to construct a mechanical buy signal illustrated on the
following chart with buy signals for an RSI3M3 oscillator:
1. The RSI3M3 drops below the buy line at 30. By dropping below the buy
line the oscillator shows an oversold condition common at cycle bottoms.
2. The oscillator turns up to show the market momentum is reversing. The
price bar that turned the oscillator up is colored or thickened (or otherwise indicate)\
to show that it is a setup bar.
3. A buy stop to go long is placed one tick above the high of the setup bar.
By waiting for the high of the setup bar to be exceeded, instead of trading on
the close, the accuracy of the buy signal is increased from 10% to 25%,
depending upon market and time frame.
4. Once a market is entered a protective sell stop is placed one tick below
the cycle bottom . Sell stops would be placed one tick below A and B. In A the setup bar was also the cycle bottom and entry occurred the following day.
In B the setup bar occurs two days before the cycle bottom, but entry occurs the day
following the cycle bottom.
Chart 8 – Mechanical Trading Signals
… reduce judgement and put you in control becausealways know the risk (entry price to protective stop).
Chart 9 - In this chart, the up arrows identify the seven trading cycle bottoms labeled 1
through 7 in the oscillator panel. The down arrows show the cycle tops. The setup bars
are marked with horizonal orange bars marking the ideal entry point. There are seven buy signals, of which six were identified by RSI3M3 identified by falling below 30. Most entries were 2 days or less from the time bottom was made and the RSI reversed to the up side. Bottom 6 was above 30. Simply raising the buy line would not have helped, as over the long term a higher buy line at 40 or 50 would have more losers than the lower buy line at 30.
But these bottoms can be identified and traded by detrending the RSI3M3.
Chart 9 – RSI3M3 Buy Signals –
Five of seven trading cycle bottoms were identified with these buy signals. The orange horizonal setup bars
are followed by entry. Five of the seven signals could have made money.
You need to spend some effort in defining automatic sell signals similiarly to what we have done with buy signals. You may want to set a stop close underneath current price when/if the RSI moves above 70?
To be continued....
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