RSI part III: Trading with the RSI
RSI part III: Trading with the RSI
For the last couple of weeks, we’ve been discussing the Relative Strength Index (RSI). The RSI is a momentum oscillator that travels in a fixed range between 0 and 100. If you have not read the prior two articles, please do so, because I won’t be reviewing any of that information in this article, in fact, I’m assuming that you have read those articles and I’ll be expanding on those concepts in this article. To read the prior articles on the RSI, click here and here.
We’ve discussed how the RSI is calculated, how it can give overbought and oversold indications, we also talked a lot about the importance of divergence. There are other ways that some traders use the RSI in their trading and we’ll be exploring a few of those in this article.
Patterns
The RSI is an interesting indicator in that it can often make patters like double-bottom and double-tops. Some traders use these patterns in their trading as well.
The chart below of Bucyrus International Inc. (BUCY), the mining and equipment making company, gives us a couple examples of these patterns.
In area A, a clear ‘W’ shaped pattern appears in the RSI and the price as well. Double-bottom patterns often lead to an increase in price and that is exactly what we had. In area B, another double-bottom pattern formed in the RSI. Although it’s not perfectly symmetrical, that’s okay, the pattern still worked. Also, it might be mentioned this double-bottom occurred after a sizable pull back in price where as the double bottom pattern in area A occurred in the context of a retracement that occurred in an upward trend.
In area C, you see a double-top pattern in the RSI. The RSI twice goes up and tags the 70 level and is rejected both times. This creates an ‘M’ shaped double top in the RSI. At the time, the price action doesn’t look too worrisome. The stock is forming a regular consolidation pattern, but the RSI indicated that something more was happening and a sizable decline was the result.
These patterns by themselves don’t give the best of trading signals, but combined with other indicators, they can be a good confirmation tool.
The next chart shows a rather large RSI double top. This chart is an ETF that tracks the Japanese Over the Counter (OTC) index. The ticker symbol is JOF, and it’s made up mostly of smaller Japanese companies.
The double-top was formed in the RSI in the overbought area. The price action itself didn’t make a double top, only the RSI did. The double-top gave a warning that another decline was soon to come. Most patterns carry more significance if they occur in the over bought and oversold areas of the RSI indicator.
Trendlines
The RSI indicator often forms trendlines just like a price chart. Like a price chart, a buy or sell signal can be given when the trendline is broken.
The chart below of Foster Wheeler LTD. (FWLT) shows how the RSI twice followed a trendline up. This corresponded to an uptrend in the price of the stock itself. You might recall that in last weeks article we talked about areas of horizontal support and resistance that often show up on the RSI, where the RSI will go to certain number and turn up from there. That level is usually higher than the oversold area of 30 when in a bull market. This trendline is very similar, instead of being a horizontal support however, you have a rising support.
I’ve used arrows to point to the places on the price chart where the RSI crossed below its trendline for the first time. You might have noticed how they didn’t get you out at the top. But then again, there aren’t many indicators and methods that get you out at the top, except for pure luck. Of course, you can minimize early exits by combining the RSI with other indicators (something we’ll talk about later in this article).
The next chart shows this RSI Trendline on a daily chart of Allegheny Technology (ATI). Once again, this got you out very early. Need I stress the fact that you should back test, combining different indicators for better performance. Oscillators, especially those that travel in a fixed range (such as the Stochastic) will often get you out too early. Using another indicator, such as the MACD in conjunction with the RSI will help keep you in the trade longer to pick up larger portions of those trends.
Just by eyeballing this chart, you could probably see that you’d have better luck following a trendline on the price action rather than a trendline of the RSI.
Combining Indicators
I’ve mentioned the need to use other indicators with the RSI to confirm buy and sell decisions. It’s really hard to trade just with a moving average, or the MACD or the Stochastic, but by combining these three indicators, you get a very good system to help identify potential trades. The chart below shows Apple Inc. (AAPL) using the 21-day Exponential Moving Average (EMA), the RSI and the MACD.
I haven’t marked all the potential buy and sell signals given by each indicator, instead, I’ve circled some sell signals that all three indicators gave in mid-May. All three were close together in time. You might notice that they are all now giving buy signals, we’ll have to see how this turns out. No system is fool-proof, that is why we have stop losses.
The next chart shows a similar situation.
The chart above is a daily chart for the electronic retailer Best Buy Inc. (BBY). This is back in 2005, when retail was a little healthier than it is now. I’ve put my crosshairs vertically on the day when the RSI broke its trendline. The RSI was above 75 and turning down and the MACD was at a high point in its normal range and also coming down and giving a red arrow. This was a great place to exit. Of course it didn’t mean the trend was totally over, but this is how trading plans are built, to give you a good return following a disciplined, systematic approach with clear entry and exit signals. It doesn’t mean catching the ultimate high and ultimate low.
You might have noticed a break of the RSI trendline in May, but the MACD didn’t give a red arrow (close, but no arrow). This is a good example of how using multiple indicators help in avoiding getting out too early.
One last chart. The chart below is daily bar chart of the S&P 500 Index (SPX). I’ve scrunched the data together so you can see all the date since 1997. You will see that when the MACD is at an extremely low level, below -30, and the RSI is also below 30, a large rally usually ensues.
As of this writing (July 11, 2008) we have only the 7th time that we’ve had both the MACD and RSI at these levels. I’ve circled these points on the chart above. I think that points A, C, and D are easy to see that the snap back rally was extreme. At point B, you got a rally as well, but not as extreme as some of the others. At E, you had a double bottom before moving up a little more slowly. Of course F was this January and we did get a good rally but that didn’t begin until mid-March. When this market rallies, it could be a big one, even if only temporarily. You’ll notice the big rallies that you had in the bear market from 2000 to 2003. These rallies just brought the market back up to resistance where the rally ended and in the case of points B, C and D, you ended up going to even lower lows.
Also, you never know when the turnaround will occur. The MACD could still move lower and not be at record low levels (remember, the RSI has a fixed range, but the MACD doesn’t). The bottoms are also not as easy as it looks on the chart above, several of these points actually made double bottoms or had extreme volatility while moving off of the lows. But it’s important to keep this in mind as you look at the chart because it wouldn’t be fun to be caught on the wrong side of a short squeeze.
Conclusion
I’ve gone over a few ways to trade with the RSI. As I’ve said before, I don’t trade with the RSI, I use the Stochastic instead. I do however use the RSI to confirm divergence that I might see on the MACD. If you decide to use the RSI, or if you already do use it, make sure you have rules established to help identify entry and exit points and be consistent in how you use the indicator. You don’t want to start using a lot of indicators in your trading, you need to avoid paralysis by over-analysis. That said, it’s still nice to know about other indicators out there and how to use them properly.
-Mark Jackman
Stock Investor Personal Coach