December 11, 2009, Newsletter Issue #135: Stock Technical Indicators - Relative Strength Index

Tip of the Week

Technical indicators that give readings within a pre-defined range are called oscillators, and these work well in trading range periods. For example, Welles Wilder´s Relative Strength Index (RSI) is derived from a formula comparing upward and downward moves, and only gives readings between 0 and 100. A high reading is defined as "overbought" and a low reading is "oversold". The reason oscillators such as RSI work well in trading range environments is that overbought situations are more likely to reverse lower and vice versa. If there is an underlying trend, oscillators that fight the trend will often be overpowered, making their signals useful only if they go with the trend. Relative Strength Index: The Relative Strength Index (RSI), an oscillator developed by Welles Wilder, measures the internal strength of a stock by monitoring changes in its closing prices. The formula for RSI is as follows: RSI = 100 - [100/(1 + RS)] Where: RS = average of upward price change over a select number of days/ average of downward price change over the same number of days As with the stochastic indicator, RSI fluctuates between 0 and 100. RSI peaks indicate overbought levels and suggest price tops, while RSI troughs denote oversold levels and share price bottoms. Absolute levels can vary in meaning from stock to stock and in different market environments. Two horizontal reference lines are normally placed at 30 (indicating an oversold area) and 70 (indicating an overbought area). These reference lines can be adjusted depending on the market environment. Some analysts move these lines to 40 and 80 in bull markets (raising the bar, so to speak) and lower them to 20 and 60 in bear markets. It is advised that traders use the "five-percent" rule - RSI spends less than five percent of the time beyond either reference line over a six-month period. You can adjust these reference lines every three months (once per quarter). There is no "holy grail" level dictating guaranteed overbought or oversold readings. RSI can stay overbought in bull markets and oversold in bear markets for prolonged periods. Like most indicators, you will become accustomed to using RSI, getting a "feel" for what works best for you. RSI typically produces three kinds of trading signals, as outlined below in order of significance. Divergence: The most significant signal is generated on "bullish" or "bearish" divergences between the RSI and the price of the underlying stock. A bullish divergence gives a "buy" or long signal and occurs when the stock price makes a new near-term low, but the RSI makes a more shallow trough relative to the previous decline. You would enter a long position as soon as the RSI turns upward from this second bottom. Place a protective stop below the stock´s latest minor low. The buy signal is especially strong if the first RSI low drops below the oversold reference line. This indicates that selling pressure is near exhaustion and a directional change (upward) is imminent. A bearish divergence that gives a "sell" or short signal occurs when prices rally to a new near-term peak but the RSI makes a lower peak than during the previous advance by the stock. This calls for selling short or purchasing a put option as soon as the RSI turns down from this second peak. Place a protective stop above the stock´s latest minor high. Sell signals are especially strong if the first RSI peak is above the upper or overbought reference line. Charting Patterns: Classical charting methods work well if filtered with the RSI. The RSI indicator can be used to validate trendlines, support/resistance, and even reversal patterns. Since the RSI is a leading or coincident indicator (never a lagging indicator), it can be used to anticipate the completions of these patterns. Reversals: Buy/sell signals can also be obtained simply by following the RSI levels. These signals should be verified by the prevalent trend in the stock. As the RSI rises above the upper reference line, bulls are in control but the stock is considered overbought and is likely vulnerable to selling pressure. When the RSI falls back below the reference line, a sell signal is generated. If the RSI moves below the lower reference line, the bears are in charge, but the stock is considered to be likely oversold and entering a "buy" zone. When the RSI reverses back above the lower reference line, a buy signal is generated. (One word of caution - don´t "fade" or bet against the prevailing trend of the stock or market.)

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