In last week's Trader's Corner I wrote about Oscillators, or the technical indicators that measure up or down PRICE MOMENTUM, with readings that can 'oscillate' between a maximum low of zero and a maximum high of 100, although neither the Slow Stochastics or Relative Strength Index (RSI) Indicators will ever reach these absolute maximums.
Extreme readings, ranging from below 20 to above 80 in the Stochastics model, or below 30 and above 70 in the RSI, are typically used in default settings in PC charting applications or on web sites that use these studies, to indicate an 'overbought' or 'oversold' condition in stocks and stock indexes.
The Moving Average Convergence Divergence Indicator or MACD for short is the third of the oscillator type technical indicators. This indicator measures overbought/oversold also, but its formula is not set to produce a number between 0 and 100. With MACD we need to look at how low or high this indicator has been relative to past weeks, months and years. The MACD was originally thought (by it's originator) to be especially useful on Weekly charts.
Last week, besides a general discussion of the concepts involving Oscillator type Indicators, I covered Stochastics in depth as to how this indicator is calculated. I'll continue this week with more of an in-depth look at the Relative Strength Index (RSI), which I myself use the most of the three. Last week's article can be seen by going back to your e-mailed Option Investor Newsletter (OIN) of 2/15 or online, by clicking here.
But first, last week's column generated this Subscriber question.
In most of my work I try to keep analytical tools simple, literally. With moving averages I use SIMPLE moving averages, nothing weighted or 'smoothed'. These other more complex formulas seem especially favored by those loving bells & whistles. But, I'd also say that the usefulness in these tools is seeing over time (the more the better) how individual stocks or indexes tend to trade relative to the moving average type and length you use.
What I've found useful in moving average LENGTHS, and that is only one of two decisions you have to make (i.e., length and 'type' of average like simple, weighted, exponential), is to employ moving average lengths based on the 'fibonacci' number series; e.g., 5, 8, 13, 21, 34, 55 (50 is most common), etc. Each number in this series is the sum of the preceding two numbers.
For Daily charts, I use the 21-day Simple Moving Average (SMA), and also 50-day and the 200-day moving averages, as they are in such widespread use. For Weekly charts I use the 8 and 13-week SMA. For HOURLY charts, I tend to use a 21-hour SMA if I use one at all. I do use a 21-day RSI often and example charts are below.
I'll have more on the topic of Moving Averages in a more detailed Trader's Corner column to come.
'OSCILLATORS' IN GENERAL AND THE RSI:
When the price trend moves up or down steeply, these indicators will also start to rise or fall steeply. They are LAGGING indicators like moving averages, as they are calculated on closing prices that have occurred over the past 5, 10, 20, etc. trading periods, based on whatever number is set as 'length'.
Oscillators are probably best known for their use in measuring potential extremes in a trend, especially in a strong up or down trend where the index or stock is defined as 'overbought' or 'oversold'. This information is useful for getting alert to timing an exit on calls or entry into puts after a steep rise in prices; or, to buy calls and exit puts after a steep decline.
Another important use of these indicators is when there is a failure of an oscillator to match prices at a new high or new low, setting up a possible bullish or bearish DIVERGENCE. Here the RSI has a key DUAL use. Besides its regular use as an overbought-oversold indicator, the RSI tends to be the best (of the 3 indicators discussed) for spotting bullish or bearish divergences as potential early warnings of a trend reversal.
While I often examine the RSI on Daily charts, a great number of examples of overbought/oversold extremes and price/RSI divergences is seen on the short-duration HOURLY charts in two key indexes using a 21-hour RSI ('length' setting = 21) below. NOTE: Charts are updated through TUES only. Recent divergent trends in prices with the RSI were suggesting possible pullbacks.
The Dow 30 (INDU) has been leading the market higher in February and there has been a question in my mind if this was precursor to another broad-based advance or a 'solitary walk of the Dow' as sometimes happens. The most recent advance to new highs above 11,100 was not accompanied by a rising 'relative strength' as suggested by the RSI (Relative Strength Index).
Looking at the RSI above, 3 overbought 'peaks' were seen at the 3 red down arrows on the extreme right. The RSI was 'overbought, overbought, overbought', but prices continued rising. Of greater interest were the declining peaks in RSI. The price trend slope of rising prices points up, the RSI slope of falling peaks points down. Opposite trendline slopes like the above equal DIVERGING trends and warn of reversals, up or down.
INDU fell Tuesday and touched key near-term support at 11050. If the Average starts to pierce this support, the bearish price/RSI divergence will have been usefully predictive for trading. Stay tuned on that!
Looking again at the same hourly Dow chart below, at earlier peaks and valleys in the hourly RSI and at one earlier price/RSI divergence, will further illustrate some points. On the extreme left (early-Jan), there was another set of diverging trendlines applied to the hourly INDU price chart and the RSI below it:
Prices climbed to new highs, but after RSI stopped following to new highs in its own readings (at point 'a'), there was a substantial decline that followed.
At point 'b', the RSI had again dipped to a level below 30 where which we've defined as 'oversold'. A short-term rally followed this but it was short-lived. At point 'c', RSI was more deeply into 'oversold' territory and this time a more substantial rally developed. This is the 'plain vanilla' use of the RSI to alert to the POTENTIAL for a counter-trend move. It's then important to watch price action for definitive clues to a reversal.
On the 'overbought' side, RSI point 'd' above was a first and sole 'overbought' reading. Prices trended sideways, with one higher high, which lacked (upside) follow through, followed by a substantial collapse. Note that the lows made in early-Feb. never were accompanied again by an oversold RSI. That and the formation of a third point on an up trendline, suggested that the price bias was UP.
Finally, point 'e' on the RSI got to an overbought reading; a pullback followed, but was short-lived. When corrections are shallow, the existing and prior trend is still dominant.
With the Nasdaq 100 (NDX) HOURLY chart below, I note a couple of recent price/RSI divergences: a bullish one in early-Feb, and a recent bearish divergence. In the later, prices go sideways as the RSI trends lower, suggesting declining 'relative strength' and the formation of at least a minor top.
This line of price resistance at 1685 in NDX above is from a prior resistance, the top end of an earlier (downside) gap. The falling RSI was a tip off to the fall that came next.
HOW RSI IS CALCULATED:
The Relative Strength Index, usually referred to as the 'RSI' was developed by a trader and market analyst named Welles Wilder back in the 70's. A simple way to understand the RSI is that it is a ratio (one number divided by another) that compares an average of up closes to down closes. There is only ONE variable, which is the length or the number of periods (hours, days, weeks, etc.) that the RSI formula works with.
The common RSI default (the preset value) for length is often 9 or 14, which is what Wilder used a lot. The RSI calculations will be based only on the number of closes specified as the length setting. The commonly used default settings are 30 to represent an oversold reading and 70 and above to suggest an overbought condition.
The optimum length settings are a function of your time horizons relative to trading or investing. 5 to 10 as the RSI length on a daily or hourly chart is appropriate for the minor trend and short-term trading. A length setting of 13 up to 21 for daily charts is good for looking at the longer trend, such as over 2-3 weeks or more. On weekly charts, my preference is an 8-week period for the RSI 8 represents a 2-month period or 1/6th of a year, which provides a good picture of the secondary trend.
RSI is derived by calculating the average number of points gained on up days, during the period selected (e.g., 13), then dividing this result by the average point decline for the same number of bars this ratio is 'RS' in a 13-period formula for RSI or 100 100/1+RS. RS = the average of 13-days up closes divided by an average of 13-days down closes. 8 or 21, or any other number, would be used instead of 13 in this example.
Every up close during this period is added and this sum is divided by the number of bars that had up closes to arrive at a simple average. Every down close during the period selected is added, then this sum is divided by the number of bars that had down closes. If 10 of 14 days had up closes, the result of this division is a ratio that rises rapidly. Subtraction from 100 of the result of the division is what makes for a 'normalized' scale of 1100.
In a period of a rapid and steady advance the RSI will reach levels over 70 rather quickly and RSI can then remain above 70 for some period of time. The reverse is true in a decline, as readings under 30 are seen.
Once the RSI retreats from high levels, it can offer an alert that the trend may be reversing. It is also true that relatively brief sideways consolidations or even a minor counter-trend movements will cause the RSI reading to back off from the preset 70/30 'extremes' and get back below 70.
The reverse situation would be where a steep decline causes the RSI to fall well under 30; a brief sideways move or counter-trend rally can put the RSI back above 30. Once a strong trend continues, the RSI can quickly get back into oversold or overbought territory again.
OSCILLATOR DIVERGENCES AS BUY OR SELL 'SIGNALS'
RSI will normally move to a new low or new high when prices do the same - this is 'confirmation' by an indicator. When confirmation does not occur, the resulting divergence is an important alert for the possibility that its signaling an upcoming reversal to the current trend.
In a sense, divergences are more important than indicator confirmations as they can provide an upcoming alert to either a buying or shorting opportunity. If the divergence is one that indicates a possible reversal to a trend that you are participating in, this is a valuable advance warning. One of the chef risks to potential gains is being caught in a trend reversal that you did not see coming and were not prepared for.
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