In today’s article we discuss a useful Swing Trading Tool, the Relative Strength Index (RSI) which can be used to identify potential pivot points where there is likely to be a change in momentum where a stock or market is overbought or oversold.
When trading the markets it is very useful to be able to identify turning points, which can lead to profitable trades in the opposite direction to the current shorter-term trend. If you can identify such turning points, you have the added advantage of a contrarian trade, so you have plenty of liquidity in the market.
One technical indicator that is useful in identifying Swing Trades is Wells Wilder’s Relative Strength Index and we will expand on this today. Not e as with all oscillators it should be not used in isolation and benefits from additional information for trend confirmation.
Swing Trading With The Relative Strength Index (RSI)
The relative strength index (RSI) is intended to show the current and historical strength or weakness of a stock or market, based on the closing prices of a recent trading period. The RSI is classified as a momentum oscillator, as it measure the velocity and magnitude of directional price movements. This indicator is available in the d2mxIRESS software and computes momentum as the ratio of higher closes to lower closes. Stocks which have had more or stronger positive changes have a higher RSI than stocks which have had more or stronger negative changes.
The RSI is typically calculated on a 14 day timeframe, measured on a scale from 0 to 100, with high and low levels marked at 70 and 30, respectively. Shorter or longer timeframes can be used depending on your investment time horizon. The RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Alternatively if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued. The more extreme the value the greater the momentum and potential reversal.
Wells Wilder’s Relative Strength Index
Wilder developed the indicator to identify overbought or oversold conditions, when the price has had a rapid move and is due for a reaction or reversal in the near-term and this can be very useful for Swing Traders who are looking for turns in the market.
The RSI measures recent trading strength of the stock or market, with the slope of the RSI directly proportional to the velocity the trend change and the distance travelled by the RSI proportional to the magnitude of the move. Wilder identified that tops and bottoms are indicated when RSI goes above 70 (overbought and is a good candidate for a pullback) or drops below 30 (oversold and is getting undervalued).
He observed that divergence between RSI and price action is a very strong indication that a market turning point is imminent. Bearish divergence occurs when price makes a new high but the RSI makes a lower high, thus failing to confirm, while a Bullish divergence occurs when price makes a new low but RSI makes a higher low. These “failure swings” are give the strongest signals when they occur above 70 or below 30 and give strong signals of an impending market reversals.
Additional RSI Interpretations
Andrew Cardwell added to the interpretation of RSI and suggested using it as a trend confirmation. Cardwell said that uptrends generally traded between RSI 40 and 80, while downtrends usually traded between RSI 60 and 20 and when there is a trend reversal the RSI will undergo a range shift. Cardwell noted that bearish divergences only occur in uptrends and that they mostly only lead to a brief correction instead of a reversal in trend. Therefore he observed that bearish divergence is a sign confirming an uptrend and vice versa and this is why the RSI should be used in conjunction with a trend indicator.
US Market
The US market as defined by the S&P500 index, has been trading in an uptrend channel since mid-2011. The S&P500 has risen for the past 32 months without a 10% decline, but the RSI has now reached above 70 for the first time in six weeks, when the last correction occurred (refer to the chart above).
The relative strength index (RSI) has provided some excellent Swing Trading opportunities and may be setting up for another one near-term. The RSI indicator has forewarned of a market reversals on at least six prior occasions both overbought and oversold (as seen in the chart below). The overbought signal in May last year was accompanied by a divergence as the index made new highs but the RSI made lower highs. This trade confirms the added interpretations from Andrew Cardwell that the pullback was likely to shallow due to the underlying upward trend.
CHART: Swing Trading – S&P500 US stock market
Aussie Market Examples – Material Sector
In the Australian market the energy and resource stocks tend to be more volatile and thus lend themselves to providing some excellent opportunities for Swing Trading using the RSI indicator and here are some examples.
BHP the giant Australian diversified miner has been trading in a fairly well defined range for the past nine months and you can see from the chart below that it has provided some great Swing Trading opportunities and may be setting up again in the near-term, as it test the lower end of this trading range. Note the overbought condition was accompanied with divergence in early November’13, for a strong reversal signal.
CHART: Swing Trading – BHP Billiton the giant Australian diversified miner
Oil Search has been trading in a steady upward channel since mid-2011 and you can see from the chart below that it has provided some great Swing Trading opportunities and may be setting up again in the near-term. The overbought RSI signal is not infallible, as was the case back in Febryuary’13, but then the divergent condition in early March’13, produced a strong reversal signal.
CHART: Swing Trading – Oil Search the PNG based energy producer
Conclusions
No matter what type of trading or investing you are doing, it is very useful to identify turning points, which can lead to profitable trades in the opposite direction to the current shorter-term trend.
The relative strength index (RSI) signal discussed here does require patience, but it does offer some great reward to risk trades, as the extreme high or low will be the area where the signal fails. The overbought or oversold RSI signal is not infallible, but if it does fail look for divergence to signal another entry.
Swing Trading can be very profitable, but you need to be able to identify potential pivot points where there is likely to be a change in momentum, where a stock or market is overbought or oversold. Today we have highlighted the RSI indicator which can be used to identify these turning points. The RSI was developed by Wells Wilder to identify overbought or oversold conditions when the price has had a rapid move and is due for a reaction or reversal in the near-term and this can be very useful for Swing Traders who are looking for turns in the market. Having identified the turning points, existing stock holders have the choice of protecting their existing position through buying insurance with options or warrants, or taking profits the position.
Note past performance is no guarantee of future performance, but if you can identify a stock that reacts well to RSI overbought or oversold conditions, then you will have an edge in your investing, with good reward to risk trades.
The Trade
When considering the type of trade that best suits your portfolio consider your risk profile. We are consistently monitoring the market and have a number of trading strategies here at D2MX that can help you swing trade or identify times when you should be looking for insurance in your portfolio of investment(s). Contact us at 1300 610 024 or advisory@d2mx.com.au.
Michael Hevern
Investment Adviser – D2MX Trading
Also in the series Stock Trading Tips for All Types of Market Environments:
Part 1: A Simple Trend Finder Scanning Method
Part 2: Going For Gold
Part 3: Top-Down Analysis – A Valuable Approach
Part 4: The Power of Compounding
Part 5: Measuring Your Trading Performance
Part 6: Insuring Your Portfolio
Part 7: Aussie Dollar Strength and Your Portfolio
Part 8: Investing in 2013
Part 9: Investing in 2013 (continued)
Part 10: Yield Investing In 2013
Part 11: Investors, the results are in!
Part 12: Show me the money!
Part 13: Leading Indicators: Copper (1)
Part 14: Leading Indicators: Copper (2)
Part 15: Mind the Gap – Trading Risk with CFDs Versus MINI Warrants
Part 16: Simply Staying With The Trend
Part 17: Use Contingent Orders To Manage Your Trading
Part 18: The Aussie Materials Sector and Your Portfolio
Part 19 (a): Going For Gold
Part 19 (b): Going For Gold (Stocks)
Part 20: Silver Lining – Trend Identification
Part 21: Trading Your View
Part 22: Christmas Season Trading
Part 23: Stocks for the 2013 Christmas Hamper
Part 24: 2014 – Transition Trading
Part 25: Stop Losses, Slippage and Risk
Part 26: Investing For Yield
Part 27: Sell In May
Part 28: Gap Trading – The OOPS Trading Strategy
Part 29: “Sell in May (Close by July)” Strategy For Banks
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.