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Over the years, technical analysts have developed a number of indicators to help them identify market turning points. One of the most popular is the Relative Strength Index (RSI). Like most indicators, RSI was developed before computers were widely used in trading, and traders relied on examples to see how well it worked.
When introducing RSI in 1978, J. Welles Wilder explained that it could be used as an oscillator to spot 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 the indictor.
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: AAPL). It is calculated over 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 AAPL and 42% of the shorts were winners. This simple strategy consistently lost money. 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 these techniques are almost impossible to apply consistently.
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 strategy. 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 moving higher.
Testing that strategy on AAPL shows that the trader would earn profits holding 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, and the risk compared to a buy-and-hold strategy was decreased. AAPL fell more than 60% from a previous high during the test period while traders would have limited losses to only 20% from the highest peak.
This improvement in performance shows that there is a better way to look at RSI than the traditional approaches. Using the direction of the RSI 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 over that time, long trades are more likely to win. If the indicator is down, 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 AAPL -- as well as the index that tracks the 100 largest Nasdaq stocks, PowerShares QQQ (NASDAQ: QQQ) -- to continue until the end of December.
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