RSI and Stochastics - notes on RSI and stochastic PDF

Preview

Summary

notes on RSI and stochastic ...

Description

RSI, Stochastics, CCI, Price-Volume Indicators Overview: Two of the most popular overbought-oversold indicators of the Relative Strength Index (RSI) developed by Welles Wilder and Stochastics developed by George Lane. While each of these indicators can be used independently, John Murphy points out that used in combination with each other they form a powerful combination. When using RSI and Stochastics, one should always apply these indicators to both the daily and weekly form of the chart. If the daily and weekly charts are not in harmony it is far more probable that the signal will be very short term. The RSI and Stochastics should of course be used in conjunction with traditional technical analysis such as the breakout from a support level or the breaking of a trendline.

Objectives: After completion of this unit you should be able to: 1. Describe how to use RSI and Stochastics in conjunction with traditional technical analysis. 2. Be able to analyze buy and sell signals given by RSI and Stochastics in conjunction with each other.

Lesson: RSI was created by Welles Wilder and described in his book New Concepts of Technical Analysis. The index measures the relationship between the average points gained in a stock over p periods in relationship to the average points lost over p periods. Thus what RSI tells the analyst is where the stock is in its trading range relative to itself over a period of time. P periods may be measured daily, weekly or even monthly. The RSI period suggested by Wilder was 14 and this is the default period which is built into most software packages and most web sites on the internet. It is possible to customize this period, however, and try to "fit" the RSI to the stock's individual pattern. While the RSI works well at showing daily overbought and oversold conditions, it can also be applied as a weekly measure to show longer term conditions. The significant points to indicate overbought and oversold on the RSI are 70 and 30. When a security goes above the 70 level it is thought of as being overbought: it has risen in price very steeply and is thus vulnerable to potential profit taking. At 30 it is oversold: many of the sellers have sold and it is likely that a rally may form from this condition. Of course, as with any other technical analysis principle, there is no guarantee that because RSI has gone above 70 or below 30 that a reversal will occur. In fact, if a stock is very strong or selling pressure is very heavy, it is possible that price main remain above or below these levels for a sustained period of time. How then are we to use the RSI as a practical trading indicator? One answer to this question is the concept of divergence between the security's price and the indicator. Let us imagine this scenario. IBM hits a price of 140 and the RSI registers an overbought reading of

72. IBM declines to 135 and the RSI declines with it to 64. A rally ensues and IBM hits a new high of 143, but the RSI only rallies back to 68. There is divergence in this situation because the security price has gone to a new high, but RSI has not confirmed this situation. If IBM now begins to decline and the RSI goes below 64 we have what Wilder called a "failure swing." Since the indicator is designed to lead a movement in price it gives the analyst a warning to take profits. The 50 level is also significant in RSI analysis. This is because 50 is the middle point between 70 and 30 as well as 100 and 0. The technical analyst will often observe that at an RSI of 50 a stock which is in an uptrend will find support and conversely a stock which is in a downtrend will meet resistance at this same level. Such signals can be used profitably. The chart below are marked to show both buy and sell signals using a daily and weekly RSI interpreted in conjunction with one another.

Stochastics were created by George Lane as another means of giving traders a warning of impending trend reversal. Stochastics measures a stock's price in relation to its trading range over a specified period of time. This period of time is usually 5, so the stochastic can be used as a very short term indicator. However, one may create a more intermediate or longer term indicator by using a 15 or 25 period stochastic. It should be noted that a 5 week stochastic is equivalent to a 25 day stochastic (5 trading days in a week) so that by combining the daily and weekly stochastic for trading signals one is "filtering" out some of the daily noise. Stochastics differs from RSI in that it gives a crossover signal to mark the end of an oversold or overbought period. Whereas RSI consists of one line, stochastics consists of two lines named %K and % D. %K is calculated by taking today's close and subtracting from that close the lowest low in p periods. This number is then divided by establishing the highest high in p periods and subtracting the lowest low in p periods.

For example, let's say IBM close today was 140 and the lowest low in 15 periods was 118. The highest high in 15 periods was 143. Calculating the stochastic one would therefore use these numbers: 140-118/ 143-118 = .88 This number would tell us that IBM was at the 88% level relative to its own trading range over the last 15 days. A % D line is then calculated by taking a moving average of IBM's price over the last 15 days. When a stock is overbought and % K crosses down through % D a sell signal is given. The reverse holds true when the stock is oversold. For stochastics, the overbought and oversold levels are 80 and 20 respectively. Again note that a security can stay overbought and oversold for long periods of time. Before trading with stochastics take a weekly and daily measure of the same security to insure both are giving the same message. The use of the stochastics oscillator is illustrated in the charts below.

John Murphy suggests a way to increase the probability of a trade being correct is to use RSI and Stochastics in combination with one another. After a buy or sell signal has been received from stochastics wait for a confirming signal from RSI. In other words if there has been a sharp decline and the stochastics goes below 20 and then gives a positive signal, wait until RSI also rallies from below to above the 30 level. The charts below illustrate both stochastics and RSI giving a buy signal on a security.

Reading: Murphy, John. The Visual Investor. Pages 97-119.

Interactivity: Go to www.bigcharts.com and bring up a chart of the Royal Bank with two years worth of information. Pinpoint a time when both the RSI and weekly Stochastics were either overbought or oversold. Next, use the daily RSI and daily Stochastics to determine when the reversal occurred....