Friday, November 9, 2012

A Lesson in Relative Strength

I'm assume you've heard of Relative Strength, also known as "RSI". If you haven't, then it's about time you became aware. If you have and think this is the same old RSI discussion as seen on most investment education sites, I assure you it's not. It seems as though there is quite a bit of confusion surrounding the Relative Strength Indicator and how to interpret what it's saying about the security being tracked.

First, let's discuss what it is not:

- It is NOT an "Overbought" or "Oversold" indicator (Use Williams %R for that)

If you think I'm crazy, there may be some truth to that, and I'll hash that out in the comments if you wish. Please bare with me while I explain.

Relative strength is exactly what it says in it's name. It measure's the strength of a securities price movement.  That also means it's a momentum indicator. As price moves up or down, RSI will "confirm" or "deny" the price movement and indicate the strength or "momentum" behind that particular move. So, if we see the price of the SPY (S&P 500 ETF) moving higher and RSI is moving up with it, the strength behind the price move is "confirmed". If the SPY price moves lower and RSI moves lower, again, the price movement is backed by the RSI, confirming the move. Therefore, when I hear someone state that a stock is oversold and ripe for a bounce because the RSI indicator is below 30, they are flat out wrong. The standard boundaries used for "overbought" and "oversold" levels are 70 and 30 respectively. The problem is if RSI drops below 30, this doesn't mean I should be buying. I should be running from it because the price action is extremely weak and likely heading lower. If RSI is above 70, that in itself may not be a reason to buy, but it certainly backs up the strength of the underlying price action. Stock's can remain overbought or oversold longer than I or anyone can remain solvent, so using RSI as an overbought or oversold indicator is a fools game.

RSI will not always "confirm" a move up or down. This is where I hear the confusion with traders or investors, and especially technical analysts touting their "skills" on CNBC. For example, let's take AAPL from this past summer and fall. I've put a chart below showing AAPL making higher highs, but during this time, RSI was heading lower. Plenty of analysts were piling on all the way to the top, and very few if any mentioned the waning strength behind the price action. This is a negative divergence and when you recognize it, it cannot be ignored. If you own a security that fits this bill, it's time to look at trimming if not outright liquidating the security. And people say charts don't warn investor's...

Classic negative divergence in RSI and Price
With RSI diverging from price action in AAPL, investors had a month long warning signal of an imminent downturn. (I will try to incorporate these scenarios as they are occurring to provide some real time examples for reader's to follow.) When a trader or investor see's this, recognize it first, then take action. If you own the stock, look to sell some or all of the stock, depending on your goals and needs. If you do not own the stock (or as a hedge if you do and simply won't sell), this is a great candidate to sell some out of the money call options to collect premium, buy out of the money puts (keep conservative targets initially in case you are wrong) or a combination of both. I'll try to cover these scenarios in another post.

Keep in mind that this is also a strategy for positive divergences. If price is making lower lows while RSI is gaining strength, this is typically signalling a reversal is imminent. Let's use the SPY as an example from this past summer:

RSI showing strength even as price makes lower lows
If we see this type of scenario, we can begin selling out of the money put options, buy conservative calls, or even begin buying shares outright. RSI when used properly is an excellent tool that can often warn of a reversal in trend before any price signal. I would recommend using this in conjunction with other indicators, such as MACD and Money Flow, but overall RSI is a very strong and reliable indicator all by itself. One helpful tip is to change the boundary lines from 70/30 to 65/35. Gains or losses in RSI strength will be easier to spot with these boundaries tightened.

I'll be on the hunt for positive divergences into this recent downward move. When I see them, I'll post a few I think worthy of acting upon.

*In other news, I'm now an uncle to a newborn nephew and there is nothing negative about that!

No comments:

Post a Comment