In a sideways-moving market, price action does tend to oscillate up and down often in a wave-like pattern. Sometimes the ranges are very clear and traders can anticipate where the price would reverse. However, there are also times when support and resistance levels are not available. It would seem that it is nearly impossible to anticipate reversals in such a market condition. However, traders can still predict potential reversals based on price action reversing from an overbought or oversold price level. This is because even in a sideways-moving market, market participants would still perceive certain price levels as too high or too low. They would buy when the price is too low and sell when the price is too high. This then causes the price to reverse back to its mean. This type of strategy is what we call a mean reversal strategy.
This mean reversal strategy makes use of a custom oscillator which can help traders objectively identify overbought and oversold price levels. It also makes use of pin bars to confirm the trade entries.
Recursive Smoothed Stochastics Indicator
The Recursive Smoothed Stochastics Indicator is a custom oscillator type of indicator that is based on the widely used Stochastic Oscillator.
The classic Stochastic Oscillator plots two lines that oscillate within the range of zero to 100. Momentum direction can be observed based on how these two lines interact. The momentum is bullish whenever the faster line crosses above the slower line, and bearish when the faster line crosses below the slower line. The range of the Stochastic Oscillator also has markers at levels 20 and 80. Stochastic Oscillator lines dropping below 20 indicate an oversold market, while lines breaching above 80 indicate an overbought market.
The Recursive Smoothed Stochastics Indicator on the other hand is also an oscillator that plots a line that oscillates within the range of zero to 100. However, instead of plotting two lines, it plots just one line. Its markers are also shifted to 10 and 90, 10 being the marker for oversold markets and 90 being the marker for overbought markets.
It also plots a line which is significantly smoother than the regular Stochastic Oscillator. It does this by using an Exponential Moving Average (EMA) component within its computation instead of the basic Stochastic Oscillator formula. Users may however modify the indicator to use a Simple Moving Average (SMA), Linear Weighted Moving Average (LWMA), or a Smoothed Moving Average (SMMA) method within its computation.
This indicator also shades the area between the line and the extreme level markers to indicate an oversold or overbought market level. The market is oversold whenever the oscillator line drops below 10 and overbought whenever the line breaches above 90. Both market conditions are prime conditions for a potential mean reversal.
Pin Bar Detector
Even with its simplicity, pin bars are some of the most reliable reversal candlestick patterns.
Pin bars are reversal candlestick patterns that indicate price reversing in just a single bar. It is a bar with a very short body on one end and a very long wick on the opposite end. The wick of the pin bar signifies price rejection. This tells us that the market has rejected the price level on the wick end of the bar which is why the price quickly reversed from it.
A bullish pin bar has a short body on top and a long wick at the bottom. A bearish pin bar on the other hand has a short body at the bottom and a long wick on top.
The Pin Bar Detector is a custom technical indicator that automatically identifies pin bar patterns. It plots a green smiley below a candle whenever it detects a bullish pin bar pattern, and a red smiley above a candle whenever it detects a bearish pin bar pattern.
Trading Strategy Concept
This trading strategy is a mean reversal trading strategy which trades from oversold and overbought market levels which would often result in a price swing moving in the opposite direction.
The Recursive Smoothed Stochastics is used to identify oversold and overbought market levels. This is based on whether the oscillator line is below 10 or above 90. This can also be easily identified since the indicator would show the area between the oscillator line and the markers whenever the market is oversold or overbought.
A mean reversal signal is then anticipated whenever the market is oversold or overbought. The mean reversal signal is identified based on the appearance of a pin bar pattern. This is confirmed by a pin bar entry signal indicated by the Pin Bar Detector Indicator.
Buy Trade Setup
Entry
- The Recursive Smoothed Stochastics line should drop below 10 indicating an oversold market.
- Enter a buy order as soon as the Pin Bar Detector Indicator plots a green smiley below a bullish pin bar pattern.
Stop Loss
- Set the stop loss below the bullish pin bar pattern.
Exit
- Close the trade as soon as the Recursive Smoothed Stochastics line touches the 90 marker.
Sell Trade Setup
Entry
- The Recursive Smoothed Stochastics line should breach above 90 indicating an overbought market.
- Enter a sell order as soon as the Pin Bar Detector Indicator plots a red smiley above a bearish pin bar pattern.
Stop Loss
- Set the stop loss above the bearish pin bar pattern.
Exit
- Close the trade as soon as the Recursive Smoothed Stochastics line touches the 10 markers.
Conclusion
Sideways markets tend to be difficult to trade if you have no means to identify potential entry points. One trading method that usually works in a sideways-moving market is a mean reversal type of strategy.
This mean reversal strategy makes use of a smoothened version of a Stochastic Oscillator and pin bars as a basis for an entry signal. It is not perfect but it does produce many mean reversal setups that could potentially produce decent profits even on a sideways market. This strategy also works best in markets with wide price swings as the price fluctuates from being oversold to overbought and vice versa.
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