Mayday! Mayday! Eject! Eject!!
Eric Furstenberg • 7 min read
Are you one of those traders who just hope for the best when a trade is just not working out like you wanted it to? While there’s nothing wrong with staying positive and hoping for the best, we can’t afford to ignore serious warning signs when they come across our path. You see, it’s crucial to be disciplined and to adhere to your trading plans, but sometimes trading parameters which are set in stone can damage your profitability. We need to be flexible enough to adapt to ever-changing market conditions. Sometimes we need to trade like a fighter pilot. If your jet is burning out you need to abandon it immediately – or face the consequences.
Let’s investigate a few important RED FLAG warning signals you need to watch out for when managing your open trades.
Rejection Candles at Price Extremes
When the price of a currency pair or other financial instrument moves rapidly in one direction and extends far from the mean, it often reaches a point of exhaustion. At this point, there aren’t enough buyers (in the event of a bullish move) to keep on pushing the price higher. This is where you need to be careful if you’re in a long position. When this happens, the price often reverses towards the mean value, which can eat up much of your floating profits and even induce a loss on your behalf. Let’s look at some practical examples:
AUD/USD Daily Chart (2016)
The black arrows mark the rejection candles which were formed during this period. These bearish rejection candles were all formed at levels which were relatively far from the mean, which is in this case represented by the 20-day exponential moving average.
Candles one, two, and four, have rather large red bodies. This indicates determined selling during these days, and obviously, a closing price which is lower than the open price. They also have wicks protruding to the topside, which indicate the rejection of higher prices. It also shows us how the bears gained control of the market by using brute force, so to speak. The bulls endeavored to push the price to new highs but were convincingly overpowered by the bears each time. Let’s zoom in to get a better view of candles 1, 2, and 4:
AUD/USD Daily Chart (2016)
These three rejection candles have a few things in common, but their most prominent similarity is the fact that they are bearish engulfing bars. Engulfing bars can be powerful reversal signals, especially if they’re situated far from the mean value (and are facing the mean value). You should be on the lookout for candles like these, especially those with exceptionally large ranges. Also, rejection candles, whether they’re pinbars or engulfing bars, are even more dangerous when they close on, or close to their lows.
Candle number three is a shooting star candle, which is also called a bearish pinbar. This type of candle is, just like one, two, and four, a powerful reversal signal.
Now let’s say you were in a good buy position, and your trade was in profit by a bit more than 100 pips. Now, as you’re keeping an eye on this profitable trade of yours, the price makes a good run but misses your take profit by a mere 12 pips. A few hours later, candle 3 is completed. At the end of the day(candle 3), you can’t believe the price reversed just 12 pips shy of your target. In the meanwhile, you’ve moved your stop loss to breakeven in order to eliminate potential losses due to sharp reversals.
This is where many traders leave all of their money right on the table. They fail to recognize that the odds have just turned against them. In this case, their stop loss is about 100 pips away from the market price. They reason, that since the pair is in an uptrend, and the price is above both the 200-MA and the 20-EMA, they are safe to hold on to their winning position. After all, there is a 100 pip cushion between their stop loss and the market price, and the price will ‘eventually reach their target in the end’.
In the meanwhile, institutional traders (who are the ones who move the market) had already begun to scale out of their long exposure to the pair, as they noticed the waning bullish momentum. Countertrend traders also notice this weakness and step in with some short positions. The following day sees continued selling, and the price drops aggressively. Let’s zoom in a bit:
AUD/USD Daily Chart (2016)
Just prior to this pinbar candle, we see a bullish candle with a long wick to the upside. This is called a ‘test candle’. It looks pretty much the same as a bearish pinbar candle, but it doesn’t exactly qualify as a pinbar due to its close which is too far up in the candle’s range. Although this test candle isn’t such a strong bearish signal as the pinbar which followed it, it is definitely something you should take note of when you encounter it.
A blue (bullish) test candle’s close should be in the lower 50% of its total range. That means, its upper shadow’s range should be at least half of the candle’s size. (A candlestick’s wicks are also called shadows).
When the pinbar candle finally closed, the technical message was pretty clear: the bulls had lost control of the market.
So what should you have done in this case? Should you have closed out your position completely, or taken partial profits and moved your stop loss higher? Should you have left your position unchanged at all? Remember, we’re looking at this chart in hindsight. We have all the answers at this moment. But when you’re in the situation where you need to make the decision, you obviously don’t know what’s going to happen. Like always, we need to consider the most probable outcome and manage our trades accordingly.
When the test candle closed, the price was about 115 pips from the 20-EMA. This is a substantial distance from this moving average, which is a good way of gauging the short-term mean value of an instrument. The large gap between the price and the mean value, combined with the bearish rejection displayed by the test candle, should have been enough evidence for you to at least scale out of your position to a certain degree. Then, when the following day turned out to be a strong pinbar, it would have been wise to consider closing out your position completely, even though your target had not yet been hit. I would personally have taken my 100 pips and ‘called it a day’. Of course, when I first started trading, I didn’t know anything about rejection candles or reversion to the mean. Neither did I know how important the daily timeframe is for technical analysis. I made mistakes most of the time.
Even when I started using daily timeframes, later on, I often held onto positions which I should have closed out immediately when I saw the red lights flashing. When you’re a novice trader, you don’t want to admit you’re wrong, and of course, you don’t have the experience to always recognize the dangers for what they really are.
As you can see in the chart above, you would have been stopped out at breakeven if you hadn’t acted proactively when you saw the early warning signals of an impending reversal. Sometimes it’s better to just take the profit you already have than to hold onto a position when the probabilities have clearly turned against you.
So far, we’ve used the combination of candlestick patterns and the distance from the mean value to identify dangerous counter-trend pullbacks towards the mean. However, there are several techniques by which you can identify possible threats to your open trades. I can’t go through all of them right now, but there’s a pretty handy tool which can help you to determine when a price movement has become overextended and may be ripe for a pullback against the prevailing trend. What are we waiting for, let’s check it out!
Relative Strength Index (RSI)
The relative strength index is an indicator which was developed by Welles Wilder many years ago. RSI is a momentum indicator which oscillates between overbought and oversold levels. These levels can be modified as well as the period input parameters. The standard RSI setting uses 14 periods in its calculation and plots the relative strength on a chart which oscillates between 0 and 100. When RSI is above the 70 threshold, the particular instrument is considered to be overbought. When it dips below 30, it is considered to be oversold.
I like to play with around with indicator settings, and I’ve found that RSI is a phenomenal tool to point out possible price reversals. Of course, this indicator needs to be adjusted to different timeframes and shouldn’t be the only factor brought into consideration when making trading decisions.
Let’s use an RSI input of 5 periods, with an overbought threshold of 75, and an oversold threshold of 25. Here is the AUD/USD daily chart again:
AUD/USD Daily Chart (2016)
Here you can see that the RSI indicator was overbought either when, or just before candle numbers 1, 3, and 4 appeared. Just before candle number 2 was formed, RSI was at 69, which is almost overbought. So in all four instances, the RSI indicator provided early warnings to bullish traders that counter-trend corrections would likely be encountered. What makes this indicator so fantastic, is that it would have alerted you of these corrections at least 24 hours before they occurred!
RSI should ideally be used in combination with other indicators, or at least with price action triggers for the best results. In choppy market conditions where deep counter-trend corrections occur, the RSI indicator is the ideal tool to warn you of imminent dangers. It reminds me of the way the baboon and monkey species here in Southern Africa operate. They have all kinds of natural enemies like large eagles, snakes, caracals, foxes, leopards, lions, etc. So they usually rely on one of the older primates in the group to sit somewhere in a high tree or rock, on the lookout for these predators. While the 'guard-monkey' is scanning the area for potential dangers, the rest of the group can focus on collecting food, grooming, and so on.
In this case, with the AUD/USD, the RSI indicator effectively provided early warning signals to traders in long positions.
Of course, RSI is a powerful tool for identifying trade opportunities as well, but in this case, we only used it to warn us of looming corrections against open positions.
Let’s look at another example of where the price reversed to the mean value (20-EMA) after a powerful rejection candle had formed far from the mean. In this case, the RSI indicator (set to 5 periods, with overbought/oversold levels at 85/15) gave an overbought reading just before this massive rejection candle appeared. Here is the chart:
GBP/JPY Daily Chart (2014)
Amazing, isn’t it! How would you have managed an open long position if you saw such an aggressive bearish rejection candle?
We need to be percipient and sagacious when managing our open trades. When we see clear warning signals, we need to re-evaluate our trade(s) and pull the ‘eject’ lever if necessary (exit the trade). Being responsive at the right time will spare you unnecessary losses.
In certain situations, you would rather move your stop loss aggressively higher instead of closing out the position. In other circumstances, you will scale out of your position (close a part of it) and trail your stop loss. This will depend on the trend structure, and how aggressive the rejection candle is.