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Establishing a stop-loss point is a balancing act with two primary functions: First, to help you stay in a trade as long as the trade is performing or has the potential to do so. Second, to help you exit the trade if it either violates the trading parameters you set or goes beyond an economic loss with which you are comfortable. The RSI-price signal formation offers a unique opportunity to visualize an appropriate stop-loss level.

From the daily trading ranges leading up to the signal, you can infer the approximate level below current price behavior where the evolving formation is either in the model or out of it. You know the per-tick value of the contract, so you can easily determine the dollar amount of loss you can comfortably tolerate. You can then adjust your trading parameters that represent your comfort zone in relation to the trading model, thus giving yourself a clearly defined optimum stop-loss point.

PATTERN FAILURE

As important as it is to be able to recognize those price-RSI patterns that succeed, you also want to be able to recognize when a pattern is not succeeding according to the tenets of our model. Understanding where things break down is as important as being able to see a potential trading signal, as this knowledge will allow you to make quick informed decisions at a time when a position may be evolving away from the model.

Complementary tools such as moving averages can confirm trading signals and help you stay in better touch with events. Pairing three - and five-day moving averages is my favorite supplementary tool.

In Figure 6, a chart of April 1992 gold, you can see the divergence in price and the RSI between January 6 and February 25. On the buy side day of February 12, price has traded up within the downward price channel, creating a spike in the RSI. The shelf-like RSI pattern that can be seen between February 14 and February 20 makes an occasional appearance in charts when price is struggling to establish support. This pattern is also visible in Figure 1.

On February 24, the closing price probes new low territory in relation to the low of January 6, and the RSI begins to accumulate support above its level of January 6. The next day, February 25, price closes marginally lower and support seems to be gathering beneath the RSI. Compare this RSI bottom formation to the one in Figure 3: The signal's pattern seems complete. The fact that prices closed at their lows on February 25 may have kept us from establishing a position on the close of this day. But the following day, February 26, prices climb slightly by the close, and the RSI appears to have reached support. The next day, prices gap up at the open and trade up for the day. By this time, more than a few traders would be aware of the technical trading opportunity at hand.

An inside day with a very narrow price range follows (February 28). Could the faltering acceleration we see here be part of the pattern? Compare the second day in this price trend with the second day in our previous examples. During the next five days of trading, price moves into a shallow downtrend. We have clearly broken from the pattern we are studying and the position should be vacated.