RSI indicator

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    In the Sept. 13 edition of Technical Tuesday, I analyzed two small-cap market

    averages -- the Russell 2000 Growth Index (RUO) and the Russell 2000 Value Index

    (RUJ), the failure of which to successfully challenge their early August highs

    does not bode well in the short-term for bulls foraging in the small-cap patch.

    In fact, both indexes are getting dangerously close to their late June lows --

    potentially very bearish occurrences. But lets put a pin in that for now.

    One of the indicators I used to interpret the technical condition of those two

    indexes in that Sept. edition was the Relative Strength Index. This market

    indicator is one of the three primary components of the trading system I use in

    my MST Trader Alert, and its certainly worthy of its own Technical Tuesday.

    The name Relative Strength Index was actually an unfortunate choice for this

    market tool. The term relative strength is bandied about frequently and

    generally refers to the relative price performance of a stock or market to that

    of another stock or index.

    However, the Relative Strength Index -- or RSI, as we market technicians refer

    to

    it -- is something quite different. Because of the similarity of its name with

    the

    term relative strength, the value actually depicted by the RSI is often

    misunderstood by those lacking a real understanding of this indicator.

    The RSI is a momentum indicator that measures the internal strength of a stock

    or

    index against itself. It was developed by J. Welles Wilder, Jr., who introduced

    the concept in his 1978 book New Concepts in Technical Trading Systems. The

    primary use of the RSI has been to evaluate the strength of the momentum of a

    stock or market average. It compares the closing prices on days that a stock or

    market average finishes higher with the closing prices on days when the stock or

    market average finishes lower -- over a specific period of time. In his book,

    Wilder used a 14-day period, which is also the time frame I use in the MST

    Trader

    Alert.

    You can certainly use other time frames. In fact, Wilder suggested a seven-day

    period to trade short cycles. A nine-day period is also commonly employed to

    trade

    or examine a stock or index on a short-term basis. And 15, 21, 25, 30 and even

    45-day periods are frequently used for an intermediate cycle. Feel free to

    experiment.

    Once youve settled on your time period, you simply plug it into your

    calculation.

    Heres the formula:

    RSI = 100 - [100/(1 + RS)]

    Average Gain = (Total Gains/n) / (Total Losses/n)

    First RS = Average Gain / Average Loss

    Smoothed RS = [(previous Average Gain) x (n-1) + Current Gain]/n / [(previous

    Average Loss) x (n-1) + Current Loss]/n

    n = number of RSI periods

    As you can see, the average gain is equal to the sum of all the gains divided by

    the number of periods youve chosen. Similarly, the sum of all losses divided by

    your chosen time period gives you your average loss. Then, divide the average

    gain

    by the average loss. Finally, the resulting value is smoothed using the previous

    periods average gain and average loss (the smoothed RS calculation).

    Math not your relative strength? Not to worry. You dont need to know how to

    calculate RSI. But knowing how its constructed does engender a better

    understanding of what the indicator value represents and how to use it properly.

    In Part 1 of our discussion of moving averages, I said that trading software

    packages will actually calculate the indicator for you. Those same software

    packages will take care of the number-crunching for the RSI as well. But if

    anyone

    ever asks you at a cocktail party how to construct the RSI, you are now equipped

    to rattle off the formula in the blink of an eye. Youll be the life the party

    (lampshade not included).

    OK, now that weve mastered all of the intricacies of the RSI formula, lets see

    what youre left with as a result of this high-level math. The value of the RSI

    ranges from 0 to 100. Traditionally -- when the RSI is above 70 -- a stock or

    index is considered to be overbought. And when the RSI has a value below 30 -- a

    stock or index is thought to be oversold. Those values go to 80 and 20 in bull

    and

    bear markets, respectively. Thus, the RSI helps you pinpoint momentum extremes

    and helps you locate turning points.

    Now, lets examine a few ways that the RSI can assist you in making trading and

    investment decisions. Operative word: assist. You should never rely on any one

    indicator or tool when forming conclusions that will affect the value of your

    trading or investment account. Always use more than one indicator. No one

    trading

    tool works all the time.

    Thats not to say you always need to employ a battery of indicators -- for some

    people, a few will suffice. In fact, using too many indicators can have a

    negative

    effect on your efforts -- you run the risk of constantly second-guessing

    yourself

    -- a common malady of many traders known as paralysis by analysis.

    But you will be well served by employing at least a few different tools that fit

    your trading or investing temperament, time frame and goals. And use these tools

    to confirm the signals you receive from one another. Trading and investing is a

    game of odds. And putting those odds in our favor increases the likelihood of

    achieving success.

    My second reason for using the word assist is that the RSI is normally not

    used

    as a primary trading indicator but, rather, to confirm another signal, which is

    how I use it -- to evaluate the strength of a momentum signal Ive received from

    another indicator.

    There are three different ways to use the RSI. The first two methods deal with

    signals generated from moves into the overbought and oversold levels I cited

    above.

    The third is the one I use in the MST Trader. Any one of these methods --

    employed properly with other valid trading setups -- can improve your results.

    The first method attempts to capture a change in momentum after a stock or index

    has become overbought or oversold. To illustrate how this concept is used in an

    actual trade, lets look at an example of buying a stock. The principle is

    exactly

    the reverse when shorting a stock or index.

    Assume that youre interested in purchasing shares of Tulip Fever (BULB). Again,

    a stock is considered oversold when the RSI falls below 30. If the RSI then

    rises

    back above 30, thats considered bullish. This positive change in the RSI value

    --

    following right on the heels of an extreme oversold reading -- is interpreted to

    be a sign of strength. Accordingly, this bullish reversal from an oversold level

    -- all other things being equal -- could provide you with an attractive entry

    point for your purchase of BULB shares.

    As I said, the principle is exactly the reverse on the short side. So if you

    were

    looking to short shares of BULB, you could wait for the RSI to rise above 70 and

    then fall beneath that level. When the RSI drops below 70, the RSI is flashing

    a bearish signal. Again -- all things being equal -- the RSI has offered you an

    attractive entry for your short from an extreme overbought level.

    The second method is a variation of the first one. This time you wait for a

    divergence to occur between the extremes in the RSI value and the underlying

    stock

    or index. Then you wait for the RSI to cross back above 30, if buying -- or slip

    below 70, if shorting.

    For example...Lets assume that the price of BULB has been falling -- as has its

    RSI value -- and that BULB makes a lower low than the previous low. But the RSI

    --

    while oversold below 30 -- makes a higher low. Thats whats known among market

    technicians as a divergence. Now, keep in mind that a higher low in the RSI

    means

    that -- based upon its recent closing prices -- the stock is exhibiting a

    greater

    degree of relative strength compared to the stocks earlier (higher) low. Thus,

    the RSI is telling you that BULB is not as weak that the stocks price action

    appears to suggest.

    If this scenario plays out as I just described, heres what you do: Wait for the

    RSI to rise back above 30. Now, consider what has just happened. You have a

    stock

    that has both formed a bullish divergence and reversed from an oversold extreme

    reading. Again -- all things being equal -- the RSI has just helped you spot an

    attractive entry point to make your purchase.

    The concept works the same for a short. When the stock or index makes a higher

    high but the RSI fails to reach the same peak, you have a bearish divergence.

    Your

    entry signal would be the RSI subsequently dropping below the 70 (overbought)

    level.

    The third method uses the 50 level -- or centerline -- as your trading signal.

    Readings above 50 are considered to be bullish. And readings below 50 are

    thought

    to be bearish. It sounds simplistic, but its not, because the RSI is best used

    as

    a complementary tool.

    And thats exactly how I use the RSI in the MST Alert -- to confirm my initial

    trade entry signal. Rather than acting on that initial signal -- from another

    momentum indicator -- I wait for the RSI of the underlying stock Im examining

    to

    confirm the strength of that momentum -- by crossing above or below the 50

    level.

    This way, Im only acting upon confirmed trading signals, thereby increasing my

    odds of success.

    But I dont act even after this confirming signal from the RSI. I use a third

    confirming indicator that...Ah, but it seems were out of time.

    Summing up...The RSI is a great role player. It helps filter out the mediocre

    trading signals and highlight the better opportunities. And the confirmation of

    strength that the RSI offers helps me trade with a greater degree of confidence.

    That alone makes its use worthwhile.

    So if youre not yet using the RSI to assist you in your buy or short entry

    decisions, give it a try. None of the methods Ive described is terribly

    complicated, and any one or all might help you buy or short a stock -- or

    purchase

    an option -- at a more optimal point. But even if it just keeps you out of some

    losing trades or lackluster investments -- the Relative Strength Index will have

    served you well. After all, avoiding losing money is a corollary to making it.

    Trade well...

    Mark Bail

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