Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Trading Tips – Continuation Patterns & The RSI3
07/31/2008 12:00 am EST
Editor's Note: Since I am on vacation this week, I wanted to share an earlier article that explained a technique that I have found to be quite useful. In the next article I will feature some examples of how this technique has worked in our current markets.
One of my favorite short-term momentum tools is called the RSI3, which is a short-term modification of the Relative Strength Index developed by Welles Wilder. I first learned about this modification of the RSI from an old friend and leading cycle analyst, Walter Bressert. It is calculated by calculating a five-period RSI then taking a three-period simple moving average of this value. The advantage of the RSI3 is that it can give you a reading as to whether the very short-term momentum was positive or negative. Unlike the standard nine-or 14-period RSI calculation, it is not useful for identifying long-term divergences.
I have also found it is quite useful in identifying and trading continuation patterns, because, while the RSI3 exhibits patterns like those on the chart, the RSI3 patterns are often resolved earlier than the chart formation. Silver prices have gotten a fair amount of attention this year, but as the weekly chart indicates, the current rally got underway in 2003, as prices rose from a low of $4.34 (450 on the chart) to $8.50. The very sharp reversal in April 2004 indicated that the gains were over for a while. Over the next 17 months, silver traced out a large flag formation as indicated by lines A and B. Below the bar chart you will see a plot of the RSI3 and by connecting the peaks from early and late 2004 you, can draw a well-defined downtrend, line C. Over the same time period, the RSI3 formed a series of higher lows (line D) and together they also form a flag. By watching the flag formations on both the bar chart and the RSI3 you will note that the resistance in the RSI3 (line C) was surpassed on September 24, 2005 (point 1), three full weeks before the flag formation on the bar chart was completed. You might be able to see this more clearly by referring to the vertical line, labeled F. Using the standard measuring rules, the price projection from the flag formation was for a rally from the breakout level at $7.82 to $11.50. Though the chart does not show it, this target was reached in April of 2006. Of course, volume is an important part of chart analysis. Although it did increase at line F, it did not move above the recent volume highs (line E) until the chart resistance was overcome. It is also important to note that as silver started surging from $7.50 to $10, the RSI3 diverged from prices. This is a clear example of why the RSI3 should not be used to determine trend strength or major turning points.
The RSI3 works just as well in downtrends and on daily, or even hourly data. Delta Airlines (DAL) was in a well-established downtrend in 2004, having dropped from a high of $16.05 to a low in May 2004 of $4.34. The RSI3 started to turn up (from oversold levels), suggesting a rebound could be underway. The first phase of the rally took prices quickly back to previous peak at $7.22, but the volume was considerably lower than on the decline. After a two-week pullback, DAL made marginal new highs at $7.25, identifying the resistance at line A and completing the flag or triangle formation (lines A and B). The RSI3 formed a very similar formation during this period, lines C and D. However, the support on the RSI3, line D, was broken with the close at $6.59 on July 6, 2004 (line F). The triangle on the bar chart was broken on an intra-day basis three days later, but DAL did not close below support at line B until five days later at $6.09. Of course, in a flag formation the volume should decline as the formation progresses and that was indeed the case with DAL. The volume shows a series of lower highs, line E, but did not increase dramatically until several days after the price support was broken.
Figure 3 is a daily chart of Bank of America (BAC) from earlier this year. In March, the bar chart traced out a flag formation, lines A and B. Because BAC had just rallied from a low of $42.75, this was likely to be a continuation pattern. The RSI3 shows a much steeper downtrend, line C, and also a short-term positive divergence, line D. Together they also form a triangle that was resolved on April 18, 2006 (point 1), with the close at $45.96. Two days later, the flag formation on the daily chart was also completed. By looking at the vertical line, labeled F, the leading action of the RSI3 is easily visible. The volume pattern was also ideal, as volume declined as prices approached the apex of the triangle, then increased as the RSI3 and chart pattern were resolved (point 2).
So what is the best way to utilize this technique in real-time? First, just look at the bar chart–remember, you should be using at least two time frames; so, if you are trading based on the daily, look at the weekly also. Figure 4 is the S&P 500 DEP Receipts (SPY), which by mid-June 2005, was moving sideways after a nice rally from 79 to 102 over the prior three months. By early August, there was well-defined resistance at 102, line A, and support at 96, line B. Because of the prior uptrend, this was most likely a continuation pattern. Once you have found a continuation pattern, add the RSI3 plot and draw trend lines just as if it were a price chart. By mid-July, the RSI3 showed well-defined support (line D), and a down-sloping line of resistance (line C). The resistance in the RSI3 was overcome on August 11, 2003 at point 1, with the SPY’s close at 98.65. The logical place for a stop was under the support at line B. Although the SPY attempted to break through resistance at line A on August 22nd, it was not successful. Six days later, at point 2, the SPY closed at 102.80 and above its resistance. When you are identifying RSI3 breakouts it is critical that you wait until the period is completed before taking any action. The only way one can validly read the RSI3 is after the completion of the period; otherwise, price extremes within the period could give misleading signals.
This is even more important if you are using this technique on intra-day data. Figure 5 is a chart of the Euro/Dollar from 2004. The Euro had just rallied from a low of 1.1962 to a high of 1.2235 in early August before it consolidated. The trading range that developed gradually grew larger, line A and B. The RSI3 formed a shallowly declining flag formation, lines C and D, with the RSI3 dropping below 20 on August 2nd. In early trading on August 3rd, the RSI3 moved above the resistance at line C, with the close at 1.2203. Three hours later, the Euro completed its continuation pattern on the bar chart as it closed at 1.2307, well above the resistance at line A. Six days later the Euro reached a high of 1.2486.Correctly identifying continuation patterns can have many applications, no matter what type of trader you are. If you are an intermediate-term trader, they can help you identify an opportunity to add to an already existing position. Daily or intra-day traders will be able to identify the multiple-day or hourly trading opportunities. Though the RSI3 will not always give you advance warning that a continuation pattern is going to be completed, it will work often enough to be a valuable addition to your technical tools. I hope you will take the time to explore it further on your own since this is essential before a trader can use any indicator with confidence on a real-time basis.
As always I welcome your feedback on these articles. I can be contacted at firstname.lastname@example.org. I would also appreciate any suggestions you may have for future articles.Tom Aspray began doing computer analysis of the financial markets in the early 1980s. He helped to introduce many of the technical tools that are now very popular though his writings and lectures around the world. He now works as a private consultant and educator.
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