Over the years, technical analysts have developed a number of
indicators to help them identifymarket turning points. One of the
most popular is therelative strength index (RSI) . Like most
indicators,RSI was developed before computers were widely used in
trading, and investors relied on examples to see how well it
When introducing RSI in 1978, J. Welles Wilder explained that it
could be used as an oscillator tospot overbought and oversold
extremes, or it could be analyzed by applying trendlines and
identifying chart patterns. Now that trading software is widely
available, we can test RSI and also try to identify ways to improve
RSI is a momentum indicator designed to show when price momentum
is changing. The traditional approach to using RSI is shown below
on the chart of
Apple (Nasdaq: APPL)
. It is calculated during a 14-day period with an overbought level
of 70 and an oversold level of 30 being highlighted.
It seems like it could be useful to sell when an overbought
market stops being overbought, i.e., selling when RSI falls back
below 70. Using this approach, "buy" signals would be given when
RSI moves back above 30 after becoming oversold. The idea sounds
like it could be profitable, but it isn't.
This idea can easily be tested and the results are untradeable.
Exiting a position a month after a signal is given, only 36% of the
long trades were profitable in Apple and 42% of the shorts were
winners. This simple strategy consistently lostmoney . Adding
trendlines to the indicator or looking for patterns like a
head-and-shoulders in the indicator data usually leads to similarly
poor trading results, because they are difficult to identify in
real time and it's almost impossible to apply these techniques in a
While RSI and almost every other indicator ever developed for
that matter, deliver disappointing results to most traders, the
general concept of momentum indicators seems logical. They are
developed to take advantage of the idea that changes in momentum
occur before changes in the trend are visible. You can see this
when driving a car on the interstate. The momentum changes faster
than the car's speed when getting on the highway and momentum slows
before the speed declines to exit the highway.
If momentum turns before price, then we should be able to see
that on the chart, and to make changes in momentum easier to spot,
RSI has been overlaid on price in the chart below. There seems to
be a close fit in the direction that RSI and prices move.
One more chart is needed to turn this into a trading
In the next chart, RSI has been moved forward by five days,
because if momentum leads price, then the indicator should shift
course before the price turns.
The differences between the two charts may be difficult to see,
but the idea is very testable. If RSI leads price, then we should
take long positions when RSI (shifted forward by five days) is
Testing that strategy on Apple shows that investors would earn
profits if they held the position for one month after RSI shifts
unlike the losses incurred in the previous test. All of the gains
were from long trades, which were profitable 63% of the time. The
risk compared to abuy-and-hold strategy was decreased. Apple fell
more than 60% from a previous high during the test period while
investors would have limited losses to only 20% from the highest
This improvement in performance shows that there is a better way
to look at RSI than the traditional approaches. Using the direction
of theRSI indicator to forecast prices can be done using data
available on many free charting sites. Simply look at whether RSI
is higher than it was five days ago to follow the example shown
here. If RSI is moving up during that time, then long trades are
more likely to win. If the indicator is down, then short positions
should be more profitable.
Many other variations of this idea are possible. Day traders,
for example, could find that shifting RSI forward by only one day
provides a significant trading edge for holding periods under one
week. Using a shorter calculation period for RSI, two days instead
of 14 for example, also improves the results (and a different
formula for RSI that I'll show next week makes a dramatic
difference in results).
Action to take -->
Based on this indicator, enter long trades expecting the rebound in
Apple -- as well as theindex that tracks the 100 largest Nasdaq
PowerShares QQQ (Nasdaq: QQQ)
-- to continue until the end of December.
This article originally appeared on ProfitableTrading.com:
New Charting Technique Signals Apple's Rally
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