It's All Relative
Greetings from the Road Warrior! I am writing this article from our New York offices having just arrived from London. While I have a moment, I figured I'd share a better method for using one of the technical indicators we discuss in our Pro Trader Course. This is not to say what we teach in the course is wrong. Remember, technical analysis is an art more than a science and there are simply different ways of analyzing price action. Remember, your trading decisions should be based on price action with the indicators being a decision support tool.
I am proud to tell you that I was recently accepted for full membership in the Market Technicians Association in anticipation of my completion of the Chartered Market Technician's Designation. I am taking my final exam this Friday after an 18 month process of study and exams. The side benefit of my studies, other than improved trading skills, is that I have learned many new techniques which I can now share with my students and the whole Online Trading Academy community.
One of those new techniques I learned from reading Connie Brown's "Technical Analysis for the Trading Professional". Now don't run out and buy this book right away. It is written for someone who has a lot of trading experience and may confuse many newer traders.
The typical Relative Strength Indicator (RSI) uses 14 periods and gives several signals. Positive and negative divergence are the strongest signals provided by the indicator. Positive divergence is where the indicator makes higher lows while the security's price is making lower lows. Generally the price will reverse and head higher. A negative reversal is when the indicator fails to make new highs while price does. Generally the price will fail and enter a downtrend. The other signal this indicator provides is an overbought and oversold status. If the indicator rises above 70 it is overbought and is ready for a pullback or reversal. Do not automatically sell at this point! If the RSI then drops below 70, that is your signal to sell or short.
A similar signal occurs when the indicator drops below 30. The stock is oversold and may reverse. Wait to buy until the indicator crosses above 30.
One thing to notice is that unfortunately in a strong bullish stock you will not get any buy signals since the RSI will not drop below 40. In a strong bearish stock the RSI does not make it above 60. So how can you hope to have the 70-30 signals get you into your trades? The answer is you can't unless you adjust the indicator. Many trading platforms will allow you to adjust the lines for overbought and oversold on your indicator. Let's see how this adjusts our trading signals.
In a bullish stock, I mentioned that the RSI will use 40 as a support. Therefore, we need to adjust our overbought and oversold signal lines upward to get quality signals. By making the overbought 80 and the oversold 50, you will have a useful indicator. DO NOT SHORT in a bullish stock! Use the overbought signal to exit longs only, not to enter short positions.
As soon as the RSI does drop below 40, we need to adjust for a bearish stock. In a bearish stock, the RSI uses 60 as resistance. So we must adjust our signal lines downward. Our overbought line becomes 50 and our oversold is 25. Sell short on a crossover 50 to the downside and exit shorts on the crossover of 25 to the upside. Do not enter longs in a bearish stock. The trend is your friend!
I have shown examples on a daily chart in a stock only. Don't worry, this technique works just as well for intraday on stocks as well as for Forex, Eminis, and anything else you can use an RSI on. Give it a try and see if you get better signals! Until next time, may all your trades be green and your losses small.
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As a former stockbroker, brokerage trader, and hedge fund trader, Brandon brings various market views and insight to his classes. A wealth of knowledge, he has held NASD securities series 7 and 63 licenses. An Online Trading Academy graduate himself in 1998, Brandon has been trading his own account since. Brandon taught for Online Trading Academy in 1999 to 2001 before becoming a Realtor and Mortgage broker holding licenses in 15 states. Returning to the Online Trading Academy family late 2005, he now balances trading, teaching and a real estate career.