In an article titled “The Sneaky MACD," dated 2/27/08, I wrote about the fact that although I am primarily a “Systems” guy, I have in recent years also evolved into something of a “Setup” guy. And that evolution continues. For the record and so that there is no confusion, let me give you my definition of these terms. A “system” involves specific rules that generate specific buy and sell signals based on specific criteria (I hope that definition is specific enough). A “setup” on the other hand is more of an “alert” that a certain set of criteria has been met and that as a result an opportunity may exist. This week I would like to highlight another potentially useful “setup."

It’s a “Setup”

This setup involves the use of two indicators that are well known to most technical traders. There are the Relative Strength Index [RSI] and the Stochastics indicators. For the purposes of this test I will use ProfitSource and the following custom settings:

• RSI ProfitSource Settings: [3, Close, 70, 30, 1]
• Stochastics ProfitSource Settings:: [10, 10, 10, 75, 25]

There is nothing “magic” about these particular settings and I urge individuals to experiment with different settings.

Sell Setups:

In order to trigger a sell setup, a few things must occur.

1.  The “fast” stochastic reading (also known as %K), must be below the slower stochastic (also known as %D).

Concurrently:

2.  The underlying security must make a new closing or intraday high (use a 20-day or a 50-day window).

3.  The 3-day RSI must NOT confirm the new high (in other words, the RSI makes a lower higher while price makes a higher high).

The setup is completed when the RSI ticks lower.

Buy Setups:

In order to trigger a buy setup, a few things must occur.

1.  The “fast” stochastic reading (%K), must be above the slower stochastic (%D).

Concurrently:

2.  The underlying security must make a new closing or intraday low (use a 20-day or a 50-day window).

3.  The 3-day RSI must NOT confirm the new low (in other words, the RSI makes a higher low while price makes a lower low).

The setup is completed when the RSI ticks higher.

Okay, what the heck was that all about, you may be asking. As usual, a simple example should help. In Chart 1 we see four setups in recent months for Apple Computer (AAPL) – three sell setups and one buy setup.

Chart 1

#1 – Sell Setup 

The first sell setup turned out to be a not very useful one. On 10/18/07, the stock made a new closing high, the 3-day RSI made a lower high and Stochastics %K stood below %D. On 10/19/07, the RSI ticked lower thus completing the sell setup. This was clearly not a very timely alert, as the stock rallied over the next twelve trading days from 170.42 to 191.79. This did however, set the stage for Setup #2. Also, the stock did ultimately fall to 153.76 by 11/12/07, thus potentially offering a profitable trading opportunity.

#2 – Sell Setup 

The second setup was completed on 11/6/07 and 11/7/07. As AAPL rose to a new closing high of 191.79, RSI established a series of lower highs and the Stochastic %K was slightly below %D. The downtick by RSI on 11/7/07 completed the sell setup. Over the course of the next three trading days the stock fell –17.5% to close at 153.76.

#3 – Sell Setup 

The third and final sell setup was completed on 12/27/07. On 12/24/07 and 12/26/07 AAPL notched consecutive new closing highs. At the same time, the 3-day RSI failed to confirm by reaching a new high and the Stochastic %K languished below %D. On 12/27/07 the RSI ticked lower and the sell setup was complete.  By February 7^th, 2008, AAPL had declined –39% to 121.24.

#4 – Buy Setup

On 2/22/08, AAPL registered a new closing low of 119.46. At this point, the 3-day RSI registered a low that was higher than the level where it stood at the time of the two previous price lows. Likewise, %K stood above %D. On the next trading day – 2/25/08, the RSI ticked higher, thus completing the buy setup. The stock closed that day at 119.74. It has subsequently risen as high as 133.27.

Summary

So is every setup guaranteed to generate a profit?  Hardly. As always, I wish to emphasize that I am not actually encouraging anyone to rush out and start trading tomorrow using this setup. Like anything else related to trading, part of the process is taking in new information, examining it, testing it and making an thoughtful determination as to whether or not that new information might do you some good. If someone were to find this setup useful, there is still the matter of deciding what to do with it. One could buy and/or sell short shares of stock, or one could trade options. If implied violability is low at the time of a setup you might consider buying a call or put. If implied volatility is high a bull put or bull call spread might be a better bet than a straight long call (and a bear call or bear put spread might be a better bet than a straight long put).

Hey, no one said this trading stuff was easy.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

For the record and so that there is no confusion, let me give you my definition of these terms. A “system” involves specific rules that generate specific buy and sell signals based on specific criteria (I hope that definition is specific enough). A “setup” on the other hand is more of an “alert” that a certain set of criteria has been met and that as a result an opportunity may exist. This week I would like to

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