"accurate" price for a particular commodity or security. This typical view is thatprice is an accurate representation of all known information at the instant in time that atrade was made. The point that I am trying to illustrate is that price is often nothing morethan a number that two traders agree to and nothing more. I realize that this is oppositeof what many "experts" say.There are many types of traders. In this example, we are using com but inreality, these types of traders exist in all markets. Listed below are just some possibleclassifications:1.
2.
Small Com Producer - knowledgeable only about his local market place and hisfarm.Large Com Producer - knowledgeable about his national market place and thefarming conditions in the nation.14
RSI: The Complete Guide
Large International Diversified Com Producer- knowledgeable about the international market place and the growing conditions internationally.4. Small Com Reseller-intimate knowledge about local market5. Medium Com Reseller - knowledgeable about national market place.6. Large International Reseller-knowledgeable about international market place.7. Small Speculator-limited capitalization, limited ability to withstand losing posi­tions.8. Medium Speculator- better capitalization with the ability to withstand losingpositions while waiting for market reversals.9. Large Institutional- Significant capitalization, lots of "brain power" with theability to hold large positions for long periods of time regardless of price move­ment.1O. Large Speculator-Immense capitalization, lots of "brain power" with the abil­ity to hold large positions for long periods of time regardless of price movement.3.
There are many more "types" of traders. Conventional wisdom tells us thatprice is an accurate representation of the com market. So, if our two com traders aresmall com producers and they agree to a price on a small amount of produce - doestheir price reflect the "fair" price for com? Do you think that a large internationalagricultural business concern like Archer-Daniels-Midland believes this is a "fair" pricefor com?I am not saying that the price agreement made by 2 small com producers is notimportant because it is. I am saying that it is important to realize that without anyknowledge of who made a trade or whether a trade was made free of force or threat,the price of a trade is nothing more than a number. This is also the number that every­one feeds into their computers for the software to crunch the numbers and display anindicator line on a computer screen.For those of you that believe that ADM or other large international concerns donot care a hoot about these two traders, I can tell you about other traders who believethat the two local com farmers have a more intimate knowledge of the growing condi­tions of com, and consequently their "price" is more valid.Our two com traders could be anyone. Let's assume that the market has justopened and we have Adam offering to buy (bidding) com at 219.00 and Bob who isoffering (asking) 220.50 for his com! They agree on 220.00, generating the first trade ofthe day. A minute elapses and Charlie decides to accept Bob's asking price of 220.50.Bob and Charlie, after conducting their business, are no longer interested in any moretrades. The increase in price causes a few other traders in the pit to see that the price15
John Hayden
is going up so they consequently jump into the action, bidding for some com, pushingprices to 225.00.Adam, seeing a chance to make some easy money, decides to sell the comcontract he purchased at 220.00 and a second contract making him short the market.This trade takes place at 225.25. Upon seeing a trade at 225.25, Charlie reconsiders hisposition and decides that now would be a good time to add to his long position by buying100 contracts. In his buying frenzy, he continually accepts the asking (or offering) price.Consequently, traders who desired to sell their com contracts see an active buyer steadilyraising the offering price to 230.00.Adam realizes that he is unable to hold his short position at 225.25 because hedoesn't have the capital to meet the margin requirements, decides to buy a contract toexit his short position. However, because of Charlie's rush to buy his large position, thesellers have raised their offer to 235.00 and will not accept anything lower! This forcesAdam to hit the ask and take a 10-cent loss! At this time an off-floor trader decides thatthese prices are unreasonable and decides to sell one and two contracts at a time toestablish a short position just as Adam had attempted earlier. However, he has thecapitalization to hold his position until prices drop and he lowers his asking price to lessthan 235.00, which was the asking price of all of the other com sellers.This off-floor trader lowers his asking price to 234.50. At this price, his offer isthe best price available to the buyers in the pit. They hit his asking price and their ordersare filled immediately. As our off-floor trader wants to establish a large short position,he lowers his offer below the other competing sellers again and his asking price is hitagain. Our off-floor trader continues to lower his offer until he has no more desire tosell, which causes the competing sellers to lower their offers.Every novice trader understands this simple example of price generation. Whatmany traders do not realize is that the price activity was conveying no more importantinformation about how healthy the current com crop was going to be in the fall than itwas forecasting the price of apples next spring. The price information was conveyingthe perception of com traders that com would be more expensive in the future. The"why" it would be more expensive was totally unimportant.Adam, with the first short position, and our off-floor trader both perceived thatprices were too high and should reverse and move lower. Unfortunately, Adam enteredhis short position too early and was forced to exit his trade with a loss. The pricingdecision where Adam exited his losing trade was not made free of duress. Adam had toexit this trade because he was unable to meet the anticipated margin call to maintain hisposition. Since this trade was made under duress, was the price high of 235.00 repre16
RSI: The Complete Guide
sentative of the market internals? Did it represent the real value of com? No, it repre­sented the value com sellers perceived in the instant of time they were focused upon.Whenever sellers agree that the price will continue higher and refuse to lower theiroffering or asking prices, you are seeing a market that has become hysterical. Justbecause com traded at 235.00 while Charlie was acquiring his position was irrelevant.
17
18
CHAPTER 4
THE REAL NATURE OF THE MARKET PLACEWhat is the real nature of the market place? The market place simply consistsof traders that are focused on a unit of time with every expectation that the market priceaction will move in their favor within their established unit of time. Traders have varyinglevels of capitalization, experience and risk tolerance. Since traders have differentlevels of capitalization, they also have different time horizons or time "envelopes" thatthey choose to focus on. When the market behaves in a certain fashion within this "unitof time," the trader who is focusing on this ''unit of time" will undertake a certain actionor actions.The reason that prices move is because of how traders perceive the realityof the market place in a certain unit of time as dictated by their capitalization,experience, and risk tolerance. " In every sense of the word, market action is a fightbetween traders focused on what the price will be doing in 5 minutes versus those whoonly care about where the market will be-in 5 days, 5 weeks or 5 months. To complicatematters a little more, some of these combatants are using their rent money while othershave more capitalization than the Gross National Product of many of the world's coun­tries!Generally, the larger the capitalization of the trader, the longer he or she iswilling to wait for prices to move in their direction. As the capitalization level increases,the ability to withstand unfavorable price action increases as well. Very well capitalizedtraders are also unable to establish large positions at one time without moving the marketprice against their position. This is why they must buy on weakness and sell on stren�.These well-capitalized traders generally "fade" the trend of the traders who are focusedon shorter time units than they are focused on.
19
John Hayden
So, what am I saying here? The price you are seeing on your computer screenis nothing more than a number. It could be the result of two "billion dollar hedge funds"agreeing to trade 10,000 contracts at a price, or it could be two producers plowing on the'back 40 acres' agreeing to trade a one lot at a price. You don't know. The price iswhere traders of different timeframe perspectives and capitalization levels cometogether in an instant of time agreeing on a certain price. In order to understandwhere prices are going, it is important to understand which "time perspective" isthe stronger force, and then go with that force."The FORCE is more your friend than the trend. "Making an attempt to determine where prices are going by using only a dailychart or a 5 minute chart (or whatever timeframe you like or want to trade in) is muchlike standing in the trading pit trying to determine which floor traders are filling orders forthe traders with better knowledge and/or capitalization. In many ways, using only onebar chart plotted in one unit of time is a losing proposition. To become a great trader, youmust develop the ability to look at price charts in different time units such as monthly,weekly, daily, 60-minute, 30-minute and 5-minute bars. You need to have the ability torecognize which timeframe (or level of capitalization) is creating the price action. Thereare times when floor traders (as shown on a 50 second bar chart) are creating all of thevolatility in the market. There are other times that it will be the 60-minute traders whoare dominating the action. While at other times, it will be the weekly traders who are thedominant force in the market.The Relative Strength Index will help identify which timeframe is in chargebecause it instantly conveys vast amounts of market information which is mostly ignoredby other traders. I am not saying that price is not important at any one moment or thatone category of trader is more informed than another group of traders. Price is ex­tremely important and even large hedge funds can go 'belly up.' What I am trying toemphasize is that the two opposing parties of a trade are often focused on differenttimeframes and have totally different capitalization levels.Conventional trading wisdom says that if Adam buys corn at 220.00 from Boband prices decline to 2 19.00, Adam is upset because he is losing money. Adam mightnot care that the price has declined to 2 19.00 or 209.00 because he is focused on a muchlonger timeframe! Should this be the case, both traders still believe that they got a fairprice and both traders are happy with their market positions.
20
CHAPTER S
PRICE BEHAVIOR & THE RSIWhat price behavior goes with or compliments the Relative Strength Indexbehavior? As we shall see, there are certain RSI behavioral characteristics that indicatecertain things such as market reversals, trends, weakening of trend. In many cases,there are certain price behaviors that coincide with this RSI behavior.
When we choose a certain unit of time to create a chart, we have decidedto focus our attention on those traders that also think that this timeframe is impor­tant. For example, if we are looking at a 5-minute chart, we will be focusing on othertraders who also think a 5-minute chart is (or might be) important. The term "timeframe"merely refers to the time interval used in creating the bars on the chart. A trader with a5-minute timeframe is looking at a chart where the time interval of each bar is 5 minutes.Likewise, a trader with a 30-minute timeframe constructs charts with bar intervals of30minutes.Let's talk about how prices move from the perspective of traders observing themarket from different timeframes. Generally, traders focus 90% of their energies onone timeframe. The other 10% of their energy is spent looking at the infinite variety ofother timeframe choices that are available. A 5-minute trader might also look at a 30minute chart, a tick chart, and a daily chart. A 60-minute trader might choose to observea 10-minute chart and a 240-minute chart. It is important to consider that the combina­tions of time unit intervals are endless.In the following example, we will use a 5, 15, 60 and 240-minute charts. Cornhas been moving sideways between 210 and 230 for the last three days. Naturally, thereare traders that sell corn every time the price approaches 230 and buy when it ap­proaches 210. In our example, today the price goes to 230 and then continues higher to230.50 making a new 3-day high. This new high is very clearly seen by 5-minute tradersusing a 5-minute chart.21
John Hayden
As prices climb above 230 on a 5, 15, 60 and 240-minute chart, in the first 5minutes of trading the current bar is going up. If we were looking at a Japanese Candle­stick chart, the candles would be all white in all timeframes. After the first 5 minutesabove 230, the price continues to climb to 232. On the 5-minute chart, there are 2 barsgoing up. On the 15, 60, and 240-minute charts, we still have only one bar movinghigher. If the price over the next 3 hours rallies to 240, we will see 36 bars on the 5minute chart reflecting this climb higher. We will see 12 bars on the I5-minute chart, 3bars on the 60-minute chart, and only the current bar in the 240-minute chart.Seldom will you see all of the bars in all of the charts moving in the samedirection. Usually, you will see a rally followed by a retracement followed by a new rallyto new highs. Because of the different time perspectives of different traders, the differ­ent charts show the struggle between the Bears and Bulls who are focused on their owntimeframes.When the price originally moved above 230, it might have caught the attentionof everyone in all timeframes or only the attention of the short-term 5-minute traders.Typically, the longer timeframe traders don't care too much if the price moves above aprevious high on a shorter timeframe chart by one or two ticks. They want to see alarger breakout or see how prices behave after the breakout. In any case, as the pricemoved above 230, the short timeframe traders noticed the breakout and began to ac­tively bid for com with the more anxious ones hitting the asking/offer price. As moreand more traders hit the offer and the number of buyers increased, the traded price ofcom is also pushed higher.This is a key point to understand- there is a limit to how long the short-termtraders will perceive that the current price is "cheap." As soon as the 5-minute tradersperceive that the last trade is no longer "cheap," the 5-minute traders will all stop ac­tively bidding for com. It is at this point that the buyers are no longer willing to buy at theoffer/ask price. This reality causes one or more sellers to accept something lower thanthe offer and prices will begin to drop. The only thing that will save the 5-minute Bullsis if the traders in the next longer timeframe believe that prices could be ready to rallyand begin to buy. For example, the 5-minute traders began to buy because prices hadrallied to a point where they had "broken through resistance" and were moving higher.For the next longer timeframe traders to also think that prices are moving higher, the 5minute traders must push prices high enough to convince them from their timeframeperspective.If the Bulls in the next longer timeframe, for instance I5-minute traders, decideto buy because of a breakout, then the 5-minute Bulls are saved while the 5-minuteBears are losing money. These 5-minute Bears are now forced to cover their short22
RSI: The Complete Guide
positions as prices continue to rally. This rippling process continues as long as thetraders in each next longer timeframe perspective enter the market in the same direc­tion.A short-term rally will fizzle if the shorter-term traders push prices higher andthe next longer timeframe traders decide that prices are "too high." These traders canbegin to short or fade the rally or do nothing, waiting to buy the retracement. Becausethe longer timeframe traders are typically better capitalized and can trade more con­tracts, they have the ability to stop this upward price movement. If the longer timeframetraders begin to earnestly sell into the rally, they will hit the bid causing the offers todecline and immediately halt the increasing price ofcorn. This activity is best revealed inthe primary as well as the shorter timeframe charts of the sellers.Once these longer-term timeframe traders begin to short the rally, they have ineffect drawn a line in the sand. They have told ALL of the shorter timeframe traderswhat price they believe is "too high." At this point, the battle of whose perception of thecom market is correct has commenced. Do the shorter-term traders have the correctperception that prices are ultimately going higher or do the longer timeframe tradershave it right?When the retracement of a rally is shallow, it indicates a stronger opinion of theshorter timeframe traders versus the opinion of the longer-term traders. Alternatively, ifthe longer timeframe traders agree with the shorter timeframe traders (that the marketis ultimately heading higher), they stand aside rather than fading the previous rally know­ing that the 5-minute Bulls will exhaust themselves and prices will retrace. This is whenthey look to enter the market. If the price of com retraces less than 33% of the priorrally, then we could say that the 5-minute Bulls are stronger and/or the 15-minute tradersagree with the shorter-term timeframe opinion. Should the Bears push the retracementto 50% or more, the 5-minute traders are probably being overpowered by a more pow­erful longer timeframe. Should the retracement be more than 66%, the traders in theshorter timeframe that caused the price movement would be in trouble.In the next section, we cover Retracement in more depth. The point for now isthat it is the shorter timeframe traders that created the initial rally and it is the longertimeframe traders that halt it, or fail to push prices higher. These short-term traders willonly bid the price higher to a point. It is at this point that the professional short-termtraders begin to take their profits. The only thing that can save the novice short-termtraders is the traders in the next longer timeframe (15 minute in this example) decidingthat prices have potential to move higher causing them to bid the price higher.
23
John Hayden
It is just as likely that prices will be pushed lower as the longer term tradersdecide that prices are too high and begin selling. After halting the rally by selling into itsstrength and forcing prices lower, the longer term traders may decide that prices are lowenough to begin buying, eventually pushing prices to new highs. This is usually doneafter pushing prices below the previous lows and panicking the shorter-term tradersallowing the longer-term traders to once again fade the shorter-term traders by buyinginto weakness. As these different timeframe traders struggle over whose perception ismore correct, the retracements and rallies reveal themselves in the bar charts and moreimportantly in the RSI. The Relative Strength Index reveals when the next longertimeframe traders agree with the shorter timeframe traders and when they disagree.If everyone agrees that prices are moving higher, market prices will move upstrongly. On the days when there is the strongest agreement, there is a limit move! Onthese days, prices move in only one direction and pity the poor trader who happens to beopposite this move!Because there are so many different markets and different timeframes in thesemarkets, it becomes extremely difficult to describe a universal sequence of bars that willindicate when the shorter-term traders are tired. Each market and timeframe is differ­ent and has a different look. This is a subject that is very complex and is well beyond thegoals of this bookAs a trader, you are looking for a certain pattern, behavior of price, or indicatorthat re-occurs in what appears to be random fashion. When this pattern does occur, itsignals a reversal in price. This pattern may not occur at every price reversal but itusually indicates a reversal with a high degree of probability. For example, when lookingat a 5-minute chart of the cash S&P 500, a price pattern that occurs occasionally justbefore prices reverse lower is 2 bullish belt hold lines with the close being at the highappearing within a rally. A quick explanation of bullish belt hold lines is that it is acandlestick formation where the open is also the low and the close is at or very near thehigh.The 2 bullish belt hold lines work whenever the 5-minute timeframe traders aredominant. When a longer timeframe enters the battle, this pattern fails. The longertimeframe could be 7, 10, 15, 18 minutes or whatever. This logic works today (2/2002),but probably will not work in the future because the market characteristics are con­stantly changing. As a result, the candlestick characteristic will need to be changed orthe number of belt hold lines referenced in the past might need to be changed.
24
RSI: The Complete Guide
You are the one to best determine what price behavior will indicate to you whena particular timeframe is dominant. I realize that this task may appear daunting, but it isnot as difficult as it initially appears. You want to discov_er a bar or candlestick relation­ship that occurs at market tops or bottoms. It is okay if this behavior doesn't work all ofthe time because the failure will indicate that a different timeframe has become thedominant player. How do you know when a particular timeframe is dominant in amarket rally or decline? When the price advances or declines and the pattern looks likea staircase, it usually indicates one timeframe being dominant.Build a chart using Japanese Candlesticks in whatever timeframe you prefer,print 30 pages of charts, identify the tops and bottoms, and begin looking for candlestickpatterns. Look at the relationships of the shadows, opens, highs, lows, and closes. Keepin mind that you are looking for relationships that occur infrequently. When they dooccur, they typically indicate a top or bottom. It is not important if they fail at times, youare using these patterns in conjunction with analyzing the RSI. The RSI is the primaryvehicle that we are going to trade with. You will use these relationships as an aid toidentify tops and bottoms.
25
26
C HAYfER 6
BASIC RETRACEMENT THEORYIn the previous chapter, we learned that the capitalization level of a trader largelydetermines the timeframe that they focus the greatest amount of energy upon. In ouranalysis, we want to know what timeframe is in control or has the momentum and alignour trading with that timeframe. As traders, we want to trade with the group that mostclosely matches our own capitalization and time horizons. However, we must alwaystrade in alignment with the strongest momentum. There are three ways to accomplishthis: a thorough understanding of price movement, retracement levels, and the RelativeStrength Index.A common question concerning timeframe is, "What is considered a long orshort timeframe?" This determination is subjective to each trader and is largely basedupon his or her capitalization. The "timeframe" generally preferred is the average pricerange within a fixed interval of time translated into money falling within the risk toler­ance of the trader. In other words, an undercapitalized trader that has difficulty meetingthe margin requirement for the S&P E-Mini may be comfortable with a $200 loss, whichcorresponds to the average range of a 5-minute bar - but would be devastated with a$2,000 loss, which corresponds to the range of a two-hour or four-hour bar. As a result,an undercapitalized trader will focus most of his energy on trading a 5-minute chart.The better-capitalized trader will focus most of his energy on trading a longer timeframesuch as the 2-hour bars.From this point forward, I will use the S&P for the duration of the book. Whenday trading, there are three dominant timeframes that have a crucial influence: the bigtimeframe (daily chart), the intermediate timeframe (30-minute chart), and the short­term timeframe (5-minute chart). Generally, this is true for all markets. In the followingexamples, I will be using a 5-minute chart. Please note that the percentages apply in allmarkets and timeframes. When position trading, the three dominant timeframes aredaily, weekly and monthly.27
John Hayden
To fully explain the theory of retracement would require another book becauseit is a very involved subject. However, the following explanations of basic retracementconcepts should suffice in understanding the RSI.Before discussing retracement theory, we need to discuss a mathematician namedLeonardo Fibonacci de Pisa, who lived in the year 1202 A.D. He decided to investigatehow fast rabbits could breed under ideal hypothetical circumstances. He wanted todetermine how many pairs of rabbits he would have if he placed one breeding pair of 2week-old rabbits in a field. Female rabbits conceive at one month of age with a gesta­tion period of one month. At the end of two months, the female can bear babies. For thisproblem, Fibonacci limited the number of hypothetical babies a female could bear at two(one female, one male). He further assumed that the rabbits would never die and everyfemale would produce two rabbits every month from the second month forward for thenext year.At the end of Month # 1, the two rabbits mate and there is 1 pair of rabbits. Atthe end of Month # 2, there is the initial pair and a new pair of baby rabbits, giving 2 pairsof rabbits. At the end of Month # 3, the initial pair has another set of babies, giving 3pairs of rabbits. At the end of Month # 4, another pair of baby rabbits is born to the initialpair and a pair of baby rabbits born to the first pair of babies born at the end of thesecond month giving us 5 pairs of rabbits. By continuing this exercise, you can see thatthe sequence is: 1, 1, 2, 3, 5, 8, 13, 2 1, 34, ... The formula is for the sequence is:f(n)=f(n- l )+f(n-2), if n>2.This sequence of numbers ( 1, 1, 2, 3, 5, 8, 13, 2 1, 34, ..) is seen in nature whenone examines the family tree of honeybees. The family tree of a male drone bee has thefollowing: one parent (male drone bees result from the queen's unfertilized eggs), 2grand parents, 3 great grand parents, 5 great-great-grand-parents, and 7 great-great­great-grand-parents. This cycle also occurs in other natural phenomenon.We can see that the Fibonacci number sequence occurs in nature by countingthe number of petals on a flower. Some flowers have a very precise number of petals,while others, if averaged, will have the following number of petals.http://www.mcs.surrey.ac.uk/PersonaIlR.Knott/Fibonacci/sheli.gif
28
RSI: The Complete GuideTable # 4 - Fibonacci Numbers in Flowers# Petals
FlowerLily, IrisButtercup, Wild Rose, Larkspur, ColumbineDelphiniumsRagwort, CinerariaAster, ChicoryPlantain,pyrethrumMichaelmas daisies
35813213455, 89
Table # 5 - The First 50 Fibonacci Numbers (numbers in BOLD are alsoprime numbers)°
55
1
89
1
144
6 76510,94617,711
2
233
2 8,657
3
46,36875,02512 1 393196,4183 17,8 11
8
3776 10987
13
1,597
2134
2 5844,18 1
5
5 1 4,229
832 0401 3462692,178,3093 524 5785 702 8879 227 46514 930 35224 157 8 1739,088,16963,245,986
Does anyone remember where the Dow Jones Industrial Average encounteredresistance in 1973 or 2000?If we place the Fibonacci number sequence in a column and divide the firstFibonacci number by the next successive Fibonacci number, we obtain the series ofnumbers in Column A. If we divide each number by the one preceding it, we find thefollowing series of numbers in Column B.
29
John HaydenTable #6
-
Fibonacci Ratio Products
Fibonacci #11235813213455891442333776 10
A
B
Row #N / Row N + 1
Row #N / Row N - 1
1.000000.500000.666670.600000.625000.6 15380.6 19050.617650.6 18 180.6 17980.618060.6 18030.6 18040.6 1803
1.000002.000001.500001.666671.600001.625001.6 15381.6 19051.6 17651.6 18 181.617981.618061.6 18031.6 1804
We can expand on the concept of dividing a Fibonacci number by a subsequentFibonacci number and get the following table (where "N" is the Row #):
Table # 7
-
Fibonacci #11
23
Fibonacci subsequent ratios .
NIN+ 1
NIN+2
NIN+3
NIN+4
NIN+5
NIN+6
1.00000.50000.6667
0.50000.3333
0.3333
0.2000
0.1250
0.0769
0. 12500. 1538
0.07690.0952
0.04760.0588
0.4000
0.20000.2500
S
0 0000
0.375.0
o 210R
0.1429
0 0RR2
0 0S4S
81321
0.62500.6 1540.6 190
0.38460.38 100.3824
0.238 10.23530.2364
0. 14710..14550. 