Trading Basics – Short-Term RSI

01/03/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In the previous article I discussed how the RSI, developed by Welles Wilder, could be a useful tool in pinpointing tops and bottoms. In particular, I recommended using a 21 weighted moving average of the RSI to better determine the RSI’s trend and confirm positive and negative divergences.

I have also found that the RSI can be modified into a very effective momentum tool. Most successful traders will agree that having “Mo” on your side can be the difference between success and failure. This modification of the RSI I first learned about from an old friend and leading cycle analyst, Walter Bressert. He recommended using a three-period simple moving average of a five-period RSI to help identify cycle highs and lows. I have found it can be used as a “confirming indicator” to help time the execution of a trade.

Figure 1

Figure 1
Click on Image for a larger version

If one is considering taking a long position, the probability of success will be greater if both the weekly and daily momentum of the major market average is also positive. In the first chart, I have shown both the S&P 500 and the NASDAQ, with the RSI3MA, at the major turning points of the past year. As Line A shows, the RSI3MA turned up on the S&P 500 during the week of August 20th, which was a positive sign for long positions. This was confirmed the next week as the RSI3MA also turned up for the NASDAQ. Both averages continued higher for the next five months. The RSI3MA on the S&P 500 turned down from overbought levels in late December (Line B) suggesting a near term top might be in place, which was confirmed by the drop below the previous lows (Line 1). The RSI3MA on the NASDAQ had been declining for several weeks already, and the weekly candle chart shows a major downside reversal pattern on the week of Jan. 7th 2005. Two weeks later, the RSI3MA dropped below its previous lows (Line 2), consistent with the completion of a trading top.

The S&P 500 held up better than the NASDAQ as it made new rally highs in early March (Line 3), but the RSI3MA formed a negative divergence (Line 3) and failed to confirm these highs. However, no negative divergences were observed in the NASDAQ. Even if you are trading individual stocks and funds, it is important to also analyze the major market changes. Identifying divergences such as this one will alert you to changes within the overall markets that may impact your holdings. You should not expect to always see divergences in the RSI3MA, as these two examples illustrate.

The most recent rally in the stock market got underway in May as the RSI3MA on both market averages dropped to the 20-30 area in late April. The second week after the lows (Line C) the weekly momentum, as measured by the RSI3MA, had turned positive for both the S&P 500 and the NASDAQ.

Figure 2

Figure 2
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Now that we have looked at the weekly picture it is important to also look at the daily data during the same time period. The RSI3MA on the daily S&P 500 had been rising since mid-April and had reached the 65 level just as the weekly RSI3MA was turning higher. There was a similar formation in the NASDAQ as it also had reached moderately overbought levels on the daily charts as the weekly was just turning higher.

In terms of entry techniques, just because the weekly RSI3MA had turned higher, it does not mean that one should have bought the opening the following Monday. In fact, the S&P 500 opened at 1171.35 and the NASDAQ opened at 1455; but after moving higher for five to six days, a setback was not out of the question. The S&P 500 corrected for the next four days reaching the 1146 area before turning higher. The pullback in the NASDAQ was much less severe, as it only corrected to the 1426 area before resuming its uptrend.

One technique I have found useful in determining favorable entry points is to buy at the mid-point of the previous week’s range. For the S&P 500, the prior week’s high was 1178 and the low was 1154 so the mid-point was 1166. As for the NASDAQ, the prior week’s high was 1460 and the low was 1415, giving a mid-point of 1437.5. The lows for the week of May 13th were 1146 and 1432 respectively, so the “buy points” were hit for both averages. The recent rally highs stand at 1243 and 1628, which are decent gains for just a five-month period.

So how does one incorporate the RSI3MA with the other indicators that we have discussed? It clearly is not a stand alone technical tool, in my opinion, but should only be used once the weekly and daily trends are determined by some combination of the Demand Index, OBV, and RSI. One of the market areas that I have been watching for the past year is the mid-cap stocks, which had been outperforming the larger cap stocks for many years. Many thought that this would change in 2005, but so far it has not.

Figure 3

Figure 3
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In this chart we are comparing the performance of an ETF (exchange traded fund), specifically the iShares S&P 400 MidCap (IJK) versus the cash S&P 500. The S&P 400 was underperforming the S&P 500 during most of 2004, as the downtrend (Blue Line) indicates. This downtrend was broken in November 2004, and retested in early 2005, before the mid-cap stocks began to shine. As the chart indicates, they have continued to be stronger as the year has progressed. So what are our indicators saying now?

Figure 4

Figure 4
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IJK corrected in March-April of this year as the OBV dropped below its MA; but since no negative divergences formed, there were no indications of an intermediate term top. In the latter part of May, the OBV moved back above its MA and continued to make higher highs with prices. Just this past week the OBV has once again dropped below its MA, but still no weekly negative divergences are evident.

Figure 5

Figure 5
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The daily analysis of the IJK does look more positive with the OBV in strong uptrend and continuing to make new highs with prices. So far there are no short- or intermediate-term divergences. The RSI3MA has also just turned up from oversold levels in the 20 area (see circle) suggesting that the correction may already be over. From the combined interpretation of the weekly OBV along with the daily OBV and RSI3MA the intermediate trend continues to look positive. Further gains this coming week and a close above the $73 level will confirm the resumption of the uptrend.

As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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