Indicator.4

Indicator No.4: A Profit-Taking Tool

The last type of indicator that a forex trader needs is something to help determine when to take a profit on a winning trade. Here, too, there are many choices available. In fact, the three-day RSI can also fit into this category. In other words, a trader holding a long position might consider taking some profits if the three-day RSI rises to a high level of 80 or more. Conversely, a trader holding a short position might consider taking some profit if the three-day RSI declines to a low level, such as 20 or less.

Another useful profit-taking tool is a popular indicator known as Bollinger Bands®. This tool takes the standard deviation of price-data changes over a period, and then adds and subtracts it from the average closing price over that same time frame,  to create trading "bands." While many traders attempt to use Bollinger Bands® to time the entry of trades, they may be even more useful as a profit-taking tool.

Figure 6 displays the euro/yen cross with 20-day Bollinger Bands® overlaying the daily price data. A trader holding a long position might consider taking some profits if the price reaches the upper band, and a trader holding a short position might consider taking some profits if the price reaches the lower band. (Refer to "The Basics of Bollinger Bands®" for more information.)

A final profit-taking tool would be a "trailing stop." Trailing stops are typically used as a method to give a trade the potential to let profits run, while also attempting to avoid losing any accumulated profit. There are many ways to arrive at a trailing stop. Figure 7 illustrates just one of these ways.

The trade shown in Figure 7 assumes that a short trade was entered in the forex market for the euro/yen on January 1, 2010. Each day the average true range over the past three trading days is multiplied by five and used to calculate a trailing stop price that can only move sideways or lower (for a short trade), or sideways or higher (for a long trade).