Working with the RSI

b JJohn
by h HHayden
d

POINT – July 7th 2010

 Our Goals
• An understanding of:
1. The nature of the marketplace.
p
2. The determination of the dominant trend.
3 The end of a contra‐trend,
3. contra trend allowing a:
• New entry in the direction of the dominant trend.
• I
Increasing
i our position
i i size.
i
4. The use of a trend determination checklist with
precise rules for trend identification.
• Increasingg our profitability!
p y
 What is the “nature” of the stock
market?
• Iff the
h marketplace
k l was s a living
li i entity
i namedd
“Miss Market” what information does she require
t live?
to li ?
– Order flow (buy and sell orders).
• Does “Miss Market” know anything else?
– No, she only understands order flow.
• Once “Miss Market” has processed the
information contained within the order flow, is it
still valuable?
– No, it has been discounted.
 “Miss
Miss Market”
Market & Google
• An
A EExample:
l
– Jan 1 2010, there are 100 traders in China that know that Google will
no longer be complying with their censoring arrangement of the
Chinese Communist.
Communist
– Does “Market” know this now (1/1/2010)? No. Why? These 100
traders are not acting on this knowledge – yet.
– As these 100 traders begin selling (1/5/10) “Miss
Miss Market
Market” begins to
understand that the order flow from China is bearish.
– The value of “Miss Market’s” knowledge decreases as she sees ever
increasing amounts of sells entering into her system.
• If you are lucky you hear a “rumor” (Jan 12) and can take action (remember
“buy the rumor and then sell the fact”).
– Once all of the order flow is done the knowledge has been widely
d
disseminated d and
d is worthless
hl (Jan
( 29).
)
– Only then will you read (March 13) about how Google is indeed
quitting China.
 “Market’s”
Market s Knowledge
• “Mi Market”
“Miss M k t” is
i aware off bearish
b i h order
d flow:
fl “Market”
“M k t” has
h fully
f ll digested
di t d Google
G l vs. China
Chi – knowledge
k l d isi
worthless.
 Understanding “Miss
Miss Market
Market”
• Consider
C id the th following
f ll i –
• Heavy selling from Asia is impacting a particular stock ‐
– A story is being communicated.
• What is the “story”? –> What information is Miss Market telling you?
Hint: the market reaction is reflecting the information left behind.
– Price – some prices can be bearish, some bullish – pending analysis
– E.g..
E g 10year Treasury increasing to 1% yield – bearish or bullish? Depends right?
– Volume
– Falling prices, rising volume vs. falling prices and falling volume ?
– Timing
– Is this on the opening, closing, during lunch or after hours?
– Market cap value change
– Is vast amounts of market cap being wiped out? Ex. BP

• TTechnical
h i l Analysis
A l i attempts to determine
d i this
hi
information.
 What is the Story?
– The market has “knowledge” – translate it!
– Once all of the order flow is done
– Is the knowledge & experience “lost” Æ No!!!
– It is captured in the history/RSI’s!
– Footprints in time, ready for understanding & interpretation
– To interpret & understand in a probabilistic framework.
– Central point is that this information can tell you a lot
about your objective/prey –
– Retracing
R t i price,i volume,
l time
ti & economici value
l change
h
– What are the tools? Computers, technical analysis, news, horoscopes, palm
readers, tea leaves, moon phases, etc..
 What is “Technical
Technical Analysis”?
Analysis ?
• Is this
hi iit??
 Is this "Technical
Technical Analysis
Analysis”??
• Trendline's
dl ' & Patterns
 Is this "Technical
Technical Analysis
Analysis”??
A Program: A Math
h Formula:
l

inputs: The beginnings of the Black–Scholes model:

FastLength( 3 ), Define
SlowLength( 10 ), S, the price of the stock .
AlertLength( 14 ), V(S,t), the price of a derivative as a function of time and stock price.
ColorNormLength( 14 ), C(S,t) the price of a European call and P(S,t) the price of a European put option.
UpColor( Yellow ), K, the strike of the option.
DnColor( Red ), r, the annualized risk‐free interest rate, continuously compounded.
GridForegroundColor( Black ) ; μ, the drift rate of S, annualized.
σ, the volatility of the stock; this is the square root of the quadratic variation of the stock's
variables: log price process.
ApplicationType( 0 ), t a time in years; we generally use now = 0, expiry = T.
ChaikinOscVal( 0 ), Π, the value of the portfolio.
AnyVol( 0 ), R, the accumulated profit or loss following a delta‐hedging trading strategy.
ColorLevel( 0 ) ; N(x) denotes the standard normal cumulative distribution function.

if CurrentBar = 1 then
ApplicationType = GetAppInfo( aiApplicationType ) ;

if BarType >= 2 then

AnyVol = Volume
else N'(x) denotes the standard normal probability density function.
AnyVol = Ticks ;

ChaikinOscVal = ChaikinOsc( AnyVol, FastLength, SlowLength ) ;

Plot1( ChaikinOscVal, "ChaikinOsc" ) ;

Plot2( 0 , "ZeroLine" ) ;
 Technical Analysis is:
• An attempt by a trader to simplify a
complicated
p reality.
y
• An attempt to quickly grasp the “reality” of
what we are focusing our attention upon.
upon
• Technical analysis binds the trader to using
numbers – he is not permitted to use non‐
subjective criteria.
 Technical Analysis is:
• Technical analysis is the creation of a
mathematical construct based upon p multiple
p
factors in a time series, which allows our
minds to quickly grasp the reality of the
situation.
Making Money with Technical Analysis

• Remember the nature of the market – it only

values unknown information.
information
• This is why trading with just moving averages or just candlesticks will put
you in the poor house! Using moving averages does not reveal unique
information.
• In other words Miss Market has made these methods ineffective because
they are widely known.
• Unique & Unknown Information Requires that:
• Your mathematical construct MUST be unique!
OR
• Your interpretation of a non‐unique mathematical construct MUST be
unique. This is our goal!
 Do you want the “red” pill or the
“blue” pill?
• H
How “deep”
“d ” do
d you really ll want to go down
d this
hi rabbit
bbi
hole?
• If you ttake
k th
the ““red”
d” pill
ill you will
ill see “reality”.
“ lit ” However
H
there is no bottom, no exoteric mathematical formula
that will ever give you the certainty you desire
desire.
• If you take the “blue” pill you will remain ignorant of
“reality”.
reality . Your life will be much simpler.
• In either case your profitability may or may not be
stellar.
• There is no correct answer regarding this. Its’ a
personal decision.
p
 The Goal of Technical Analysis
• The discovery of unique information.
• The forecasting of the more probable “event”.
event .
• In the end it is the desire to decrease
uncertainty,
i and
d increase
i profitability.
fi bili
• Is the abilityy to hear Miss Market before
everyone else.
 Definition of a Profitable Trader:
• Th
They interpret
i t t market
k t iinformation
f ti b better
tt ((and
d earlier)
li )
than other traders!
• They must have the ability to gain the knowledge of
“Miss Market” before she has fully discounted “this”
knowledge.
• A trader who takes profits and min. loss.
• A trader that can gain “Market’s” knowledge in a
predictable manner,
manner apply it consistently and have
infinite number of trades.
• Ability to apply unique knowledge & skills.
skills
• A trader that has a lot of self‐discipline.
 Definition of a Profitable Trader:
• You must either have:
– Inside knowledge
g – often illegal.
g
– Unique knowledge – not illegal.
• You
Y mustt actt on this
thi knowledge!
k l d !
 The “Relative Strength Index “ (RSI)
by W. Wilder
• Created in: 1978
• A very widely used indicator.
• Available in almost all charting applications.
• It is a momentum based indicator, based upon
the use of a time series of pprice data.
• It is the only “public” indicator I still use.
• However, I use it in a very unconventionall way.
 The “Relative Strength Index “ (RSI)
by W. Wilder
• It is
i a “b
“bounded”
d d” iindicator
di – (0 to 100).
00)
• Its value is based upon the momentum of the ratio of higher closes to lower
closes.
• It is important to remember that the RSI value acts logarithmically. As its value
approaches its upper or lower bounds it moves less in relation to the movement of
the underlying price.
 Bullish & Bearish Divergence
• A
Any momentumt based
b d indicator
i di t will
ill h
have iinstances
t where
h
the indicator under‐performs price behavior creating either
a bullish/bearish divergence.
• In other words, if price action is making a new low (a lower low) but
yet the value of the indicator (RSI) is not making new lows then we
can say that the behavior of the RSI is diverging from that of the
price behavior, i.e. its’ underperforming.
• If this diverging behavior is seen while price is making new lows
then it is said that the “RSI is showingg a Bullish Divergence”.
g
• Likewise if the behavior of the indicator (RSI) is diverging from price
action as price is making new highs then it is said that the “RSI is
showingg a Bearish Divergence”.
g
 Bullish Divergence
• A “Bullish”
“ ll h” Divergence implies
l a ““Bull”
ll” market
k – yes??
 Bearish Divergence
• A “Bearish”
“ h” Divergence implies
l a ““Bear”” market
k – yes??
 # 1 on our Trend Determination Checklist:
Bullish & Bearish Divergence
• Remember
R b that:
th t
• “Bullish Divergence’s” – come in a Bear Market!
• “Bearish
Bearish Divergence
Divergence’s”
s – come in a Bull Market!
• A divergence is only a “detour” in the primary trend. It is
indicating a contra‐trend.
• The smaller the period is between the bars – the more
significant the divergence becomes!
• Prove it to yourself:
• Identify a long term Bull trend, then look for a “bullish
divergence” – there are none!
• Identify a long term Bear trend, then look for a “bearish
divergence” – there are none!
 Moving Averages
• A moving average is based on past prices and
defines the current trend, but does not indicate
the future trend.
• It is very effective at removing “noise”,
noise , or a price
which exceeds one standard deviation from the
data stream.
stream
• Because of their mathematical formula there is a
time
i lag
l ffrom whenh prices
i change
h direction
di i and d
the moving average changes direction.
 Common Moving Averages Formula’s
Formula s

• There are several mathematical constructs used by traders.

The most common are:
ƒ Simple Moving Averages (SMA)
ƒ Calculates the total closing price over ‘n’ days then divide by ‘n’.

ƒ Weighted Moving Averages (WMA)

ƒ Calculated by assigning a varying ‘weight’ to each closing price
over prior ‘n’ days, then obtain the average. The ‘weight’ is greater
f ‘‘yesterdays’
for t d ’ close
l vs. and
d the
th decreases
d arithmetically
ith ti ll to t zero on
the n’th day.

ƒ E
Exponential
i lMMoving
i Average
A (EMA)
ƒ Calculated similarly to the weighted moving average, however the
weight assigned is to the entire data series is done exponentially.
 Using Moving Averages
• Place a 9 period simple moving average on the
close,, and another one on the RSI.
• Place a 45 period weighted moving average on
the close
close, and another one on the RSI
RSI.
• Arrange the panels so that the price action in
on the top panel, and the RSI panel is on the
bottom panel.
Using Moving Averages
 # 2 on our Trend Determination Checklist:
Fast & Slow Moving Average Trends
• We
W can determine
d t i 2 types
t off trend
t d using
i moving
i averages.
• Fast Trend: Where is the ‘value’ which is being calculated in
relationship to the ‘fast’ moving average (the 9 period SMA in
this
h instance)?)? In other
h words d is the
h close
l above
b the
h SMA, or
below it?
ƒ Above it = Uptrend.
ƒ Below it = Downtrend
• Slow Trend: Where is the faster moving average in regards to
the slower moving average?
• If the faster moving average is above the slower then it’s a uptrend, or
vice versa.
• Generally I will say that the moving averages have gone “positive” (the
f t is
faster i above
b the
th slower),
l ) or that
th t they
th have
h gone “negative”
“ ti ” (the
(th
slower is now above the faster).
Disadvantages of Moving Averages
• That there is a significant time lag in moving averages.
• That every trader in the universe has access to the same moving
averages – no unique information.
information
• Combining moving averages on different indicators in
j
conjunction with pprice and then usingg them together
g is not a
significant unique advantage.
• The only way to use moving averages to your advantage is to
use a moving
i average whichhi h is
i constructedd uniquely
i l –
unfortunately these are very expensive and computationally
intensive.
 Bull/Bear RSI Range
Range’ss
• Forget everything you have read, here is the
real deal:
ƒ If the RSI is above the ‘60’ level, the bulls are in
charge!
ƒ The bulls stay in charge until the RSI goes under
the ‘40’
40 level.
level When this happens the bears are in
charge.
ƒ The
Th cyclel repeatst once th
the bbulls
ll manage tto gett
the close above 60.
 Bull/Bear RSI Range
Range’ss
• The Bullish RSI Range: 40 to 80
• The Bearish RSI Range: 60 to 20
• Remember:
ƒ That the RSI behaves logarithmically – as the RSI
becomes overbought or oversold it takes an
increasing drastic price move to maintain those
RSI levels.
ƒ The RSI can become overbought/oversold and stay
there for a longg time!
Bull/Bear RSI Range
Range’ss
# 3 on our Trend Determination Checklist:
What is the current RSI Range?
• Trend is up when the RSI range is: 40 to 80
• Trend is Down when the RSI is: 60 to 20
 Definition of a Trend
• Definition of a Up‐Trend:
• Higher Highs & Higher Lows & most importantly what
was Resistance is Now Support.

• Definition of a Down‐Trend:
• LLower Highs
Hi h & Lower
L Lows
L & most iimportantly
l what
h
was Support is Now Resistance.
 Momentum Discrepancy Reversal
Points (MDRP)
• Thi
This conceptt I learned
l d in
i 1996 in
i a series
i off seminars
i
by Andrew Cardwell a C.T.A (at the time).
– Mr. Cardwell offered live seminars covering many aspects
of technical analysis not covered in any books. One of the
many concepts he taught was what I now call M.D.R.P.
– Mr.
Mr Cardwell was in turn introduced to the concept of the
RSI generating buy/sell signals while he was working as a
futures broker by a client of his who trading pork bellies.
• The concept applies to ANY momentum based
indicator.
• Once understood,
understood you can use a mathematical formula
to generate price targets and a risk:reward ratio.
 Definition of a Momentum
Discrepancy Reversal Points (MDRP)
• In any momentum based indicator there are instances where the indicator
over‐performs (or exceeds) price behavior (the opposite of a divergence
which under‐performs price action).
• In other words,
words if price action is not making a new low relative to a
previous low i.e., a higher low, yet the value of the indicator (RSI) is
making a lower low vis‐a‐vis the previous price low then we can say that
there is a discrepancy in the behavior of the RSI. This is the opposite of a
divergence.
• If this diverging behavior is seen while price is making a higher low and yet
the RSI is making a lower low, then it is said that there is a bullish
discrepancy in the RSI
RSI. This is often a point in time where prices then
reverse higher i.e., a MDRP‐Buy signal.
• Likewise if price is making lower lows and yet the behavior of the indicator
(RSI) is making higher highs,
highs then we can say that there is a bearish
disprepance in the RSI. Since this is often a point in time where prices
reverse lower we call it a MDRP‐Sell signal.
An Example of a MDRP‐Buy
MDRP Buy Signal
ƒ A low
l close
l ((point
i t A)
A), ffollowed
ll d by
b increasing
i i prices,
i then
th
followed by declining prices which are still more than the close
at point “A’.
ƒ Now
N compare the th currentt RSI value
l tto th
thatt att point
i t ‘A’ – is
i the
th
RSI value lower? If so then we have a potential MDRP‐Buy
signal.
ƒ If after
ft a period i d off declining
d li i close’s
l ’ we gett a up close l (point
( i t B)
the RSI will also increase, creating a ‘hook’. If the RSI value at the
low (the day before the hook) is less than point ‘A’ and the price
is greater then we have a locked in MDRP‐Buy
MDRP Buy signal.
signal
ƒ We can determine the upside price target on either the
“potential” or “locked in” signal by taking the difference
between points A and B and then adding it to the highest close
between points A,B.
 MDRP Buy Chart of ‘GLD’
MDRP‐Buy GLD
• An Example of a MDRP
MDRP‐Buy
Buy on ‘GLD’ 10/28/09
– We have a new low on 9/25/10 @97.00 (A)
– Followed by a rally to a high close on
10/13/10 @ 104.26
104 26 (C).
(C)
– Followed by a decent (B) to 10/28/10 @ 100.73
– Note the “Bear Divergence”.
– Target
a get = (B
( – A)) + C
– 107.99 = (100.73 – 97.00) + 104.26
– Note the RSI value at ‘B’ was 48.85
indicating the bulls were still in charge.
– If we entered a bull trade when the
high (97.81)of the 25th was negated
and we used the low of the 25th (96.77) as
our exit stopp then our risk was $1.06
$
(96.76 – 97.82) .
– Yet our targeted gain was $3.73 giving was
a risk:reward ratio of 1:3.5 – not a bad ratio!
 Momentum Discrepancy Reversal
Points (MDRP)
• Things
Thi tto R
Remember:
b
– The strength of a MDRP signal depends upon the number of
bars (time periods) between points A & B. The shorter the
b
better. In other
h words d a MDRP‐Buy signall with h onlyl 1 bar
b (2(
periods) is much stronger than a MDRP‐Buy with 20 bars
between A & B.
– MDRP reversal points (B) are always significant
support/resistance levels – regardless if the price target is hit or
not.
– The price target is validated only when the close exceeds the
targeted level (an intra‐day high/low doesn’t count).
– A MDRP signal
g which fails (price
(p target
g is not hit)) is just
j as
significant as a signal which works.
– The price at point ‘B’ is always important. It will become future
pp or resistance depending
support p g upon
p the trend!
 MDRP Sell Chart of MON)
MDRP‐Sell
• An Example of a MDRP
MDRP‐ Sell on MON
– We have a new high on 1/19/10 @ 81.42 (A)
– Followed by a decline to a low close (C) on
2/8/10 @ 74.21
– Followed
F ll dbby a rally
ll to hi
high
h close
l (A) 2/17/10 @ 7878.10
10
– Note the “Bull Divergence” at ‘C’.
– Target = (B – A) + C
– 74.21 = (78.10 – 81.42) + 74.21
– Note the low RSI value just prior to ‘C’ was
28.75 indicating the bears were now in charge.
– If we entered a bear trade when the
low of the 17th (77.61) was negated
andd we usedd th th 17thth (78.80)
the WMA off the (78 80) as
our exit stop then our risk was ‐$1.21
(77.60 – 78.81) .
– Yet our targeted gain was $3.39 giving was
a risk:reward ratio of 1:2.8 – not a bad ratio!
– Note: We used the RMA value instead of the high
of the 17th as the high was 78.49 very close to the
RMA.
 Momentum Discrepancy Reversal
Points (MDRP)
• Remember:
– That the MDRP is NOT lookingg for a topp or a
bottom.
– The MDRP is looking for the end of a contra
contra‐
trend, allowing you to enter into a trade with a
high reward to risk ratio
ratio.
– The best MDRP signals are:
• Wh
Where the
th period
i d is
i small.
ll
• The first signal opposite the previous trend.
 # 4 on our Trend Determination Checklist:
What MDRP Signals are we seeing?
• If we are seeing MDRP‐Buy Signals then the
main trend is UP.

• If we are seeing
i MDRP‐Sell
S ll Signals
Si l then
h the
h
main trend is DOWN.
 Trend Determination using the RSI
‐ Bull Market
• ABBullll trend
d iis your friend!
f i d!
• Step # 1: Are we seeing Bear Divergences?
• Step # 2: What are the moving averages telling us?
– What are the moving averages on price telling you? Ideally
b th the
both th ffastt ttrend
d ((close
l > SMA) and
d th
the slow
l ttrend
d
(SMA{close} > WMA{close}) are bullish.
– What are the moving averages on RSI telling you? Ideally
both the fast trend (RSI > SMA) and the slow trend
(SMA{RSI} > WMA{RSI}) are bullish.
• Step # 3 What is the range of the RSI? Is it 40 to 80?
• Step # 4 Are we seeing only MDRP‐Buy’s?
 Trend Determination using the RSI
‐ Bear Market
• A Bear
B trendd iis your friend
f i d ((even more so than
h abbull)!
ll)!
• Step # 1: Are we seeing Bull Divergences?
• Step # 2: What are the moving averages telling us?
– What are the moving averages on price telling you? Ideally
b th the
both th ffastt ttrend
d ((close
l < SMA) and
d th
the slow
l ttrend
d
(SMA{close} < WMA{close}) are bearish.
– What are the moving averages on RSI telling you? Ideally
both the fast trend (RSI < SMA) and the slow trend
(SMA{RSI} < WMA{RSI}) are bearish.
• Step # 3 What is the range of the RSI? Is it 60 to 20?
• Step # 4 Are we seeing only MDRP‐Sell’s?
 Trendline’ss based upon MDRP
Trendline
• Significantly
f l Valid
l d Trendline’s
dl ’ can be
b drawn
d based
b d upon MDRP points ‘A’
‘ ’
and ‘B’.
Trend Determination using the RSI
‐ What
Wh SSymbol
b l iis this?
hi ?
‐ Bear or Bull?
Trend Determination using the RSI
The Only Divergence that “works”!
works !
• A Hidd
Hidden Divergence
Di Signal!
Si l!
• It is nothing more that a Divergence in the middle of
th chart!
the h t! It is
i “hidden”
“hidd ” because
b mostt traders
t d only l llookk
for a divergence at the top or bottom of the chart.
• They “work”
work because almost all of the time the price
will do exactly as the name implies!
• Remember that they still follow the same rule as a
“regular” divergence i.e., Bullish Divergence’s come in
a Bear Trend and vice versa!
• Look at the previous chart – the hidden bearish
g
divergence’s are highlighted.
g g
 MDRP’ss are everywhere!
MDRP
• Every momentum based indicator has
divergences
g and MDRP signals!
g
• Investors Business Daily in Thursday’s edition
looking at commodity charts.
charts
• Stochastic’s
• MACD
• ROC andd so on.
 Closing Thoughts
• Using
U i RSI Theory
Th we can:
1. Make the “Trend Our Friend”.
2. We can identify the trend – using our rules.
3. We must the patience to wait for a contra‐trend to appear.
• We patiently wait for the momentum of the RSI to overextend itself (the
rubber band is now taunt) vis‐à‐vis a previous price and its correlated RSI
value.
• Only then do we go fishing for that bull or bear fish.
4. Our protective stop (puke up point) is known to us at the time of
entryy allowingg us to define our risk to reward ratio,, and if we
actually want to go fishing.
• Our goal is the discovery of “Unique Knowledge”!
• Being the first with this knowledge is our “edge”!
edge !
• Remember that large traders (the elephants) always leave
footprints that we can use to either fade or go along with.
 A “Sounding
Sounding Board”
Board for traders
traders.
• It is my attempt to solve some trading problems.
problems In particular:
– Provide professional traders a way to solve their problem of sizing a trade.
– Provide a way for system/program developers to check their methodology against a different
time tested methodology.
– Provide
P id a fair
f i way off pricing
i i search
h a service
i .
• PlentyOfStocks.com provides a database of various trend indicators, buy/sell
signals, and exit strategies all based upon unique mathematical constructs.
• Compliments a traders unique approach against my approach – a sanity check?
• Registered users have access to a free historical database which include MDRP
signals and other much more advanced indicators. The only limitation is that no
data is provided which is more recent than 30 days ago. Registering is free.
• Those
h traders
d who h want current d data may subscribe
b b to the h service.
• Access to current(today’s) is limited to 100 traders.
• The monthly fee is determined by a monthly auction. The 100 traders with highest
bid will each pay what the lowest bid was (out of those 100 highest bidders).
bidders) This
prices the service most fairly. This is the same auction used in selling Treasury
debt.
 Resources
• Books:
– The 21 Irrefutable Truths of Trading: A Traders Guide to Developing a Mind to Win, by John
Hayden
– The Disciplined Trader: Developing Winning Attitudes, by Mark Douglas
– The
Th ZZurich
i hAAxioms,
i b
by Max
M G Gunther
h
– Peaks and Valleys: Making Good and Bad Times Work For You – At Work and in Life, by
Spencer Johnson
• Websites:
– RealClearMarkets.com – News for traders – free, links.
– FirstVolgaInvestments.com – Where I post various graphs and comments.
• Newsletters:
– The Gartman Letter – TheGartmanLetter.com
TheGartmanLetter com
• Programs:
– ThinkOrSwim.com – Trading Platform
– TradeStation.com – Trading Platform and Brokers.
– DataSharks.biz – Download Free Stock, Futures, and other data from around the world.
– eSignal.com – Independent real time data provider of FOREX, Stock, Options, and Futures
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