2008 Update - Continuation Patterns & The RSI3:

08/14/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In the original article, I discussed how the RSI3 could be used to identify and trade continuation patterns. As I noted at that time, 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 5-period RSI then taking a 3-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 9- or 14-period RSI calculation, it is not useful for identifying long-term divergences.

Looking at the first half of 2008 there have been countless examples of how the RSI3 helped identify continuation patterns, and I wanted to share a few of more recent examples.

Figure 1

Fig 1

Of course, for the last part of 2007, and so far in 2008, the financial stocks have been the primary focus of those who follow the US stock market. When the banks and investment house stocks have plunged, so has the market, and when they rally, they give the general market a boost. The Financial Select Spyders (XLF) is one ETF that is closely followed and has turned out to be an excellent trading vehicle. In March of 2008, XLF made a multi-year low at $22.29 before starting a decent rally with the overall market. Over the next two months, the XLF traced out a nice flag formation (lines a and b). The XLF made a high of $28.17 on May 2nd, slightly exceeding the 38.2% resistance level but fell well short of the 50% retracement resistance at $29.22. The XLF closed below trendline support (line b) on May 9th (line 1), and on the same day, the RSI3 violated its support at line c. In my experience, at least half of the time, the RSI3 will lead prices but did not in this case. XLF moved sideways and in a narrow range for over a week before heavier selling took over. The 161.8% downside projection from the continuation pattern had targets at $18.71, which were exceeded in the middle of July. The RSI3 formed a short-term positive divergence in July (line e), and similar divergences were also noted in some of the volume indicators such as the Demand Index. Though such daily divergences are not always indicative of such a strong rally, they can be useful as an early warning sign that risk is increasing on the short side. The divergence was confirmed when the RSI3’s downtrend (line d) was overcome on July 16th. XLF gained over 15% in the next few days.

Figure 2

d

Another dominant story in 2008 was the oil market and the United States Oil Fund (USO), an ETF, has developed a wide following. USO tested the December 2007 lows in the $68-69 area both in late January and early February 2008 (line b). During this period, the RSI3 formed higher lows (line d), which were positive. Downtrends were evident in both price and the RSI3 (lines a and c), and the downtrend in prices were broken a day before the RSI3 resistance was overcome (line 1). This short-term bottom resulted in a dramatic rally to the $88 area which was reached by mid-March. Once again USO formed a three-week consolidation pattern (lines e and f). A similar flag formation was formed in the RSI3 (lines g and h) with the RSI stronger than prices (line h). This time, the RSI3 broke out to the upside (line 2) ahead of prices, and once again USO moved sharply higher.

Figure 3

f

One of the financial stocks which has been near the front of the financial crisis has been UBS AG (UBS), the large Swiss based money center bank. UBS peaked in late April 2007 at $57.92 (point 1) and then began what has turned out to be a major slide. By August 16th, UBS was trading at $44.28 (point 2) and began to rebound. The rally into early October formed a flag (lines a and b) and retraced 50% of the decline from the April highs. The rally stalled well below the 61.8% retracement resistance at $53.30. The RSI3 formed a short-term positive divergence at the August lows (line c) and this uptrend was not violated until October 16, 2007 (line 3). Twelve days later, prices gapped through price support on very heavy volume of 23 million shares. Towards the end of November, UBS again stabilized at the 161.8% projection target with another short-term positive divergence (line d) evident in the RSI3. The rally that followed was quite sharp but failed to move above the 61.8% retracement resistance of the prior decline. By December 17th, with UBS closing at $41, the RSI support was broken (line 4). As of July 30, 2008, UBS closed at $19.46.

As I mentioned in the original article, the signals are not always as clear as they were in the case of UBS and sometimes you do not see continuation patterns form on both the price and RSI3 charts. When they do, the signals can be very profitable, but of course the proper risk management strategy must be always be in place. Fibonacci retracement and projection analysis is also an essential ingredient as they can be used to determine your entries and exits. I hope you will also look for the daily charts on Moneyshow.com as they often feature the RSI3 and should provide you with additional examples of how it works.

.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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