Relative Strength Index (RSI) is a well known and much used momentum indicator. It was invented by J. Welles Wilder Jr., a great technical analyst. RSI compares the magnitude of a stock or index's recent gains to the magnitude of it's recent losses and that information is turned into a number that ranges from 0 to 100. A single parameter is used, the number of time periods for the calculation. 14 periods is recommended by Wilder. Common practical use of RSI in stock market timing is to measure the underlying strength of the market and to determine if it's getting overbought or oversold. Wilder's own recommendation was to use 70 and 30 levels, to indicate an overbought and oversold market, respectively. If RSI rises above 30 it's considered bullish for the stock or index. If the RSI falls below 70, it's a bearish sign. Bullish & Bearish Divergences
Stronger buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and underlying prices. For example, a falling market index whose RSI instead rises from a low point of 10 and back up to above 50. The underlying index will often reverse it's direction soon after such a divergence. Divergences that occur after an overbought or oversold reading, usually gives more reliable signals. Center Line Break
A bullish or bearish indication is given with readings above and below the 50 level. A reading above this center line indicates that average gains are higher than average losses. A reading below 50 indicates that bears are winning the fight. For confirmation of bullish and bearish signals, some traders look for moves above and below 50, respectively. Below is the author's special indicator combination and settings, for short & medium term stock market timing. Daily Chart:
- 200 ema (exponential moving average)
- 89 ema (closing prices used for both ema calculations)
- RSI set at 25 periods with horizontal lines at 60 and 40 Weekly Chart:
- Walter Bressert's Cycle10 plotted with horizontal lines set at 70 and 40
- MACD plotted with Signal Time Periods set at 5 By the use of a 25 period RSI on a daily chart, in combination with Cycle10 and MACD, plotted on a weekly chart, larger tops and bottoms can often be found. This special indicator setup can be a contributing factor for more accurate stock market timing, although no guarantees are given. Examples for 2005 are the significant April and October lows in the OEX, (S&P 100) where the RSI dipped below 40. Later in 2005 and so far in 2006, three RSI moves above 60 all alerted about important OEX peaks, in November, January and March. Below is how i use this as an alert system in my own technical analysis: By using this 25 period RSI, instead of the standard 14 RSI, some whip-saws will be filtered out. When RSI 25 climbs above 60 or falls below 40, odds are greater more significant tops and bottoms are forming, respectively. This part of the system acts as a warning, a trading opportunity shows up on the Long or Short side and more attention is given. Long (Bullish) Entry Parameters:
Weekly MACD must be in bearish mode (closing prices). When Daily RSI closing readings falls below 40, (for a bullish entry consideration) weekly Cycle10 must be in it's buy zone (below 40) and make a positive reversal on a weekly closing basis, before entry. It's important to separate between the daily and weekly charts used for each indicator. A less aggressive approach is then to wait for the high of the weekly bar that caused the Cycle10 reversal, to be broken by a few points. Depending on the risk tolerance, a protective stop can be placed a few points below the swing low or below the low of the bar which caused the weekly Cycle10 reversal. When weekly MACD's signal line crosses it's moving average, a bullish trend reversal confirmation is given. Taking Profits
Deciding when to take profits is often viewed as the most difficult part of trading. I would consider taking profits, when the 38.2%, 50% or the key 61.8% Fibonacci retracement levels (of the previous bearish trend) are reached. It depends on how overbought the market has become, when those Fibonacci retracement levels are touched. Another, usually slower approach, is to simply take profits when MACD turns bearish again (MA crossover). The odds for a successful trade would increase if weekly MACD has just been through a bullish divergence pattern formation first, before entering bullish mode (MA crossover). Other profit taking suggestions are when weekly Cycle10 makes a bearish reversal up in it's sell zone (closing basis). A drawback with this method, is that Cycle10 doesn't always reach it's sell zone, before making a bearish reversal. Another good point to take profits, is those times when the key 61.8% Fibonacci price level is reached and Cycle10 at the same time is in it's sell zone. In this case a bearish Cycle10 reversal is not waited for. Any market wants to reach it's key 61.8% Fibonacci zone, 60-70% of the time, before making a new trend reversal. Short (Bearish) Entry Parameters:
Weekly MACD must be in bullish mode (closing prices). When daily RSI rises above 60, weekly Cycle10 must be in it's sell zone (above 70) and make a bearish reversal on a weekly closing basis, before entry. Again, a less aggressive entry, is then to wait for the low of the bar which caused the Cycle10 reversal, to be broken by a few points. A protective stop can be placed a few points above the swing high or the high of the weekly Cycle10 reversal bar. When MACD's signal line crosses it's moving average, a bearish trend reversal confirmation is given. Taking Profits The same suggestions as for the Long entries, it depends on how long you are willing to stay in the trade. When the 38.2%, 50% or the key 61.8% Fibonacci retracement levels (of the previous bullish trend) are reached.
When weekly Cycle10 makes a bullish reversal down in it's buy zone.
When the key 61.8% Fibonacci level is reached and Cycle10 at the same time has entered it's buy zone, without waiting for a bullish reversal.For your profit taking decisions, the 89 and the 200 EMA, plotted on the daily chart, can also be used as important resistance and support levels to be aware of. In general, not more than 2-5% of the total trading capital should be at risk in any trade. This prevents the trading account from being wiped out, when a streak of losses may occur, as can happen in any system. The trading strategy outlined in this article is in no way the "holy grail" of stock market timing. It's an opinion of when important market tops and bottoms can be expected and hopefully be useful information in this regard, a tool in the tool box, if you like. (c) Copyright Arild Myklebust |
