This article was written in 2007.
While the use of Relative Strength
Index (RSI) to get technical buy and sell signals in a range-bound market is
well understood, the use of this indicator in a trending market is more
intricate. This article covers the use of RSI over the three types of market
conditions namely uptrend, downtrend and range-bound or sideway market. We will
explore the concept of support and resistance levels which can be used to enhance
the accuracy of the RSI signals.
RSI developed by J. Welles Wilder, is
a powerful indicator used to measure the velocity of the price movements.
Unlike other momentum indicators such as Stochastic that have wide variations
even with little overall price movements, RSI is immune to such drawback due to
the way its value is calculated. In brief, RSI values are affected by the
number of days that the price closes up and the number of days that the price
closes down over a certain time period “t”. Commonly used periods for t are 14
and 21 days. In this article, we will use t = 14, the period originally
proposed by Wilder.
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RSI In A Sideway
Market
Technical signals are obtained by
setting two levels, typically a high level at 70 and a low level at 30 where
RSI above the 70 level is considered overbought condition while RSI below 30 is
considered oversold condition. An example of the application of RSI is shown in
Figure 1. We observe that during the August 2006 to December 2006 period,
SembMar was trading within the range of $3.20 to $3.58. In such a sideway
market that is showing no bias of significant upward or downward price
movement, RSI works quite well in identifying the tops (RSI in overbought
region) and bottoms (RSI in oversold region) of the price movement.
Figure 1: Example of using RSI in a
sideway market
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RSI In Trending
Market
In cases where the price of the stock
is trending upward or downward, the overbought and oversold levels have to be
changed. This is because RSI being an oscillator that oscillates between 0 and
100 will stay high in an up-trending market as there are consistently more days
where prices go up as compared to days when prices go down. Conversely in a
down-trending market, we expect RSI to stay at low values. Using the same
values of 70 for overbought level and 30 for oversold level will mostly result
in wrong signals such as entering and exiting too early or no signal. Such a
scenario is illustrated in Figure 2 where RSI did not even drop below the
30-level as Capitaland trended strongly from $2.80 all the way to $5.00. In
this case, using the 30-level did not generate any entry signal for a long
position. Moreover keeping the 70-level causes Capitaland to be in overbought
condition for long periods of time.
Moving upward both the overbought and
oversold levels to 80 and 40 respectively as illustrated in Figure 3 now
provides clearer trading opportunities. In such up-trending stocks, notice that
the oversold signals actually provide opportunities to enter for a long
position during the short-term downtrend (retracement) in the longer uptrend
price movement.
On the other hand, for RSI trading
opportunities for down-trending stocks, the overbought and oversold levels have
to be shifted downward to 60 and 20 respectively.
The examples of setting different overbought
and oversold levels for different market conditions highlight the importance
for technical analysis practitioners to adapt their use of technical indicators
and indicator settings for different market conditions.
Figure 2: Example of oversold level at
30 for a stock in an uptrend
Figure 3: Example of oversold level at
40 for a stock in an uptrend
To trade solely based on RSI is not
sufficient. Other concepts of technical analysis such candlestick formations,
trendlines and other western indicators must be added to the trading strategy
to serve as confirmation of the signals and to increase the accuracy of the
trading signals. Next, we will employ the concept of support and resistance to
confirm the entry and exit signals generated by RSI.
Support &
Resistance
Support
and resistance are very important concepts in technical analysis. While it is easy
to understand, its application is usually not so straight-forward owing to the
many support and resistance lines that can be drawn on any given chart. On the
price chart, we will emphasize on lines that have more contact points with the
price structure. Another important point to note is that a resistance line which
was providing resistance to price movement will provide support if this level
is broken. Conversely a support line will become a resistance line once it is
broken. This is illustrated in Figure 4.
Figure 4: Example of support and
resistance levels
Application Of
RSI With Support And Resistance
To increase the effectiveness of the
technical signals, we will buy near support level while RSI is in oversold
condition. Take note that the trend must first be determined in order to select
the appropriate values for the overbought and oversold levels. Figure 5
illustrates the application of this simple strategy on SGX. As SGX is in an uptrend,
the overbought and oversold levels are set to 80 and 40 respectively. Two
excellent bullish technical signals were generated in July and December 2006
when RSI was in oversold region while the price was near the support levels.
In fact, the above scenarios can be
easily captured using an automated system, saving you significant amount of
time and hunting down stocks which present excellent trading opportunities. One
such software is ChartNexus XPertTrader (see Figure 6) which can be used to
automatically screen the market for stocks that have RSI, MACD, Stochastic
bullish and bearish signals. More details can be found at http://www.chartnexus.com
Figure: Example of the application of
RSI and support level to identify bullish signals
While the sections above introduce you
to a simple strategy of using RSI signals coupled with the support and
resistance concept, it is important that you still adopt proper money
management, stock selection and rotational plays techniques in addition to the
timing analysis showcased in this article.
Figure 6: ChartNexus XPertTrader
screens the whole market for technical signals
This article first appeared in Smart Investor in 2007.
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.
