Traders need reliable ways to identify an emerging trend.
Just as importantly, they need to know when that trend is fading out or reversing. The latter is a cornerstone of my mean reversion strategy.
And technical indicators are a powerful tool to help traders spot these types of stock movements.
Over the past week or so, we’ve reviewed a few key indicators we use at The Opportunistic Trader, including Bollinger Bands and Moving Average Convergence/Divergence (MACD).
So today, I want to review one more signal that can improve your trading success…
Riding Momentum
The Relative Strength Index (RSI) is a popular indicator that gauges changes in momentum.
A stock’s momentum helps traders identify the strength or weakness of any move.
Ideally, you want to buy a stock when momentum is climbing. And you want to avoid doing so when momentum is falling.
Beyond that, though, the RSI helps identify when a stock is vulnerable to a reversal. It can spot when a stock is overbought or oversold – and likely to turn around.
The RSI takes the size of the average up move over a certain time frame. Then it divides it by the average size of the down moves over the same time.
The RSI converts the result into a number between 0 and 100. Below 30 typically means a stock is oversold, and above 70 means it is overbought.
You can see an example in the chart of the Energy Select Sector SPDR Fund (XLE) below…
Energy Select Sector SPDR Fund (XLE)
Source: eSignal
The RSI appears at the bottom of the chart. When the RSI nears overbought territory (red circles) and then drops, XLE also tops out and retraces lower.
And when the RSI nears oversold territory (green circles) and then rebounds higher, XLE bottoms out and starts to rally.
It’s not an exact science. But this illustrates why traders can find it so useful…
You can exit trades when momentum is starting to dry up. Or you can also use a reversal to enter a new trade.
The default setting for the RSI is typically 14 “time periods.” So if you use a day chart, it represents the last 14 days of data. With a weekly price chart, the RSI shows 14 weeks of data.
That’s why you’ll often get a different reading when you switch between different time periods.
(Note that the RSI’s calculation doesn’t change no matter what time setting you use. The default is always the last 14 time periods.)
To avoid confusion, it’s best to pick one time period (for example, a day chart) and stick with it for a trade.
That way you’ll be entering and exiting with the same RSI price data.
And you can choose your preferred RSI period based on your trading style.
For example, a trader who expects to hold a position for a couple of days or a couple of weeks would typically use a daily chart.
And someone who trades over a shorter time frame (intra-day) might use an hourly chart.
Just use a chart that best reflects the time you’re likely to hold the trade.
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Customize the RSI
The default RSI settings are good for traders starting out.
But as you get more advanced, you have the option to customize the RSI’s parameters to suit your needs.
For example, if you’re trading something volatile like crypto, you could increase the RSI period from 14 to 20.
This way, the RSI would average moves over a longer period. That removes some of the volatility from its readings. That means it could provide fewer false overbought and oversold signals.
Alternatively, you can adjust the overbought and oversold levels. Some traders use 80/20 instead of the standard 70/30 levels. Again, the aim is to reduce false signals.
The key is to test out the combination of settings to see what works best for what you’re trading and your preferred time frame.
In the end, the RSI can be a great tool to help identify potential trade setups – especially when you combine it with other technical indicators.
And because it’s chart-based (and not driven by emotion), it can help take the stress out of trading.
Are there any other technical indicators or trading concepts you’d like to see in a future essay? Send them to feedback@opportunistictrader.com.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict