always wait for an overbought oroversold condition to happen before taking profits. The point & figure chart with its ethos ofreversal patterns can be an excellent tool to use.A good example occurred in late August 2002. The swing chart of the FTSE index gave a buysignal at 4307 and, after a stutter, the market climbed up to 4466. Happily that was enough totake profits or half profits (150pt gain). But supposing the index had got up to 4450 and had thenfallen back to make the formation below on the 20pt point & figure chart. You haven’t takenyour profits, but the market gave a clear sell signal on 20th August when the FTSE fell to 4340.Not a difficult decision to liquidate any long positions.
Sell
fig 9.1153
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Of course, the signals from a low box value chart such as the 20pt point & figure chart do notnecessarily suggest a major move. One might expect a 100-140 point fall following the abovesignal (5 to 7 boxes) before the market regrouped. In fact, on this occasion, the FTSE fell over300 points without giving any swing chart sell signal on the way, so acting on that triple bottomsignal certainly would have saved a lot of money.Effectively one can use a low box value point & figure chart to isolate points where a short-termtrend may break down.Note that although excellent use can be made of the point & figure chart, the sell signal does notoccur anywhere near the top of a move. It comes only after a period of congestion results in theformation of a pattern, and then breaks down. So, in my opinion, it is not really an option to baseyour entire method of taking profits only when there is a point & figure sell signal, which is why Ihave arbitrary profit targets. The point I’m trying to make above is that in the absence of any betterindication, the point & figure chart will often protect part of your profits, or limit your losses. Byfocusing on the relevance of congestion areas, it tells you something that the swing chart does not.
Integrating p&f charts and swing charts whentrading individual equitiesWhen trading equities, primacy is given to the point & figure chart. But I don’t merely use theFTSE index swing chart for the purpose of determining the overall market trend. The swingchart of the equity is also extremely useful in 3 main situations and I never trade an equitywithout checking its own swing chart to see what is revealed.a. On occasion the point & figure chart of an equity will generate a sell signal in an uptrend ora buy signal in a downtrend. Apart from looking at the index point & figure chart to see whetherit too is changing trend, the swing chart of the equity may reveal that far from breaking down,the stock is in the process of completing a swing high or low, after which the main trend is likelyto continue.Look at the Barclays chart on the next page. In July 1993 Barclays was in an established uptrendwhen it stalled at 490p and it appeared to give one of my favourite sell signals, the descendingtriple bottom with falling highs, as it traded at 465p.
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Descending triplebottom sell signal ?
fig 9.2
Time to check the swing chart. In fact the swing chart was not bearish at all and it would takequite a lot to turn it bearish. You can see how the last clear swing low in Barclays had occurredon 7th May 1993 at 417p. The market had moved up and sideways for over two months. Therewere several occasions when there were two down days followed by inside days and furthersideways to up movement, but there was no clear swing low after 7th May. It was overdue.When Barclays traded at 465p (the putative sell signal on the point & figure chart), it was on itsthird day down and it seemed much more likely that it was creating a swing low. If a newdowntrend was in the offing, it would be more typical for the market to move up from the swinglow and then fail. Alternatively, a breach of the support between 450-455p would give a pictureof a massive top formation. So it should have been an easy decision not to act on the descendingtriple bottom at 465p.
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Swing low
Swing low
fig 9.3That is an example of the swing chart countermanding what I would otherwise regard as a strongsignal on the point & figure chart.b. As I hope I have demonstrated, the first continuation of trend signal is the best opportunityfor mechanically identifying a potential linear phase. When trading equities I am keen to take aposition when the equity’s swing chart gives its first continuation of trend signal even if there isno convincing signal on the point & figure chart. Of course if the point & figure actually looksnegative (positive), I will not buy (sell).c. Some traders may be sufficiently convinced by swing charts to use them as their primary chartto trade equities. The point & figure chart can provide a useful cross-reference.Royal Bank of Scotland (RBS) made a swing low at 1790p on 14th March 2002 (fig 9.4), andafter staggering up for a few days, it breached the swing lows on 25th March. This was alsoreflected as a breach of a double bottom on the point & figure chart. So the picture was negative,although no outright sell signal had been given on the point & figure chart.Cross referring to the FTSE chart it was clear that the FTSE was making a swing low, notchanging its trend. I mentioned this in Investors Chronicle at the time. So there was noindication to sell RBS. Indeed, it was possible that if the FTSE rallied strongly off its swinglows, a bullish shakeout buy signal would be generated by the RBS point & figure chart.
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Swing LowLooks like swing chartsell signal
Sideways movement
fig 9.4But on 8th April the FTSE performed a similar manouevre of staggering up a bit then floppingthrough its swing low. So now the FTSE swing chart was negative and the RBS charts werenegative. Time perhaps to sell RBS? No. No bearish sell signal had been given on the 20p point& figure chart. More suspiciously, the price action since the breach of the RBS swing low wassideways. Then on 9th April, the 10p box RBS chart which had been definitely bearish turnedaround and gave a triple top buy signal as it traded through 1830p (fig9.5) . . .
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Buy
Sideways movement onbar chart translates intobase formation here
fig 9.5
. . . and the bullish shakeout buy signal, which always seemed a possibility, was in fact given onthe 20p chart on the same day when RBS traded through 1840p.It was clear that the swing chart sell signal was a trap. RBS roared ahead. Watching the point &figure simultaneously with the swing chart was a huge help.In the first draft of this book, there was at this point a lengthy example of trading the softwareshare, Sage, throughout 2001 using the full combination of point & figure integrated with swingcharts as well as the RSI (which I deal with in the next chapter). But my publishers and I thoughtthat the reader may have the charting equivalent of white line fever by this stage of the book, sothe Sage example has been consigned to Appendix 3.
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TailpieceIntegrating point & figure with swing charts is an essential part of my charting technique. Butas it involves so much use of judgment, because it so impressionistic, it is difficult to convey thefull range of it with precision. It is impossible to lay down a set of rules. It is said that technicalanalysis is more of an art than a science, which I always think is a bit of a cop-out, but it is trueas regards this aspect of my method. I’m afraid it is something you’ll have to twiddle withyourself, perhaps in conjunction with your own favourite type of chart, to arrive at a method thatsuits you.
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10
RSIAND OTHER INDICATORS• An explanation of RSI• Weekly RSI• Other indicatorsMoving AveragesThe Coppock IndicatorBullish Percent chartsCandlesticksRelative Strength
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An explanation of RSIRSI stands for relative strength index which is a pity since it doesn’t measure relative strength,but momentum. As a result, it is always known by its acronym RSI to distinguish it from theindicator which does measure relative strength.I use the RSI mainly for exiting positions. Knowing when to close a position is one of the mostdifficult parts of technical analysis. There are 3 reasons for keeping a close eye on the RSI.a. It tells you something other charts do notb. It marks market highs and lowsc. It assists in the tricky task of taking profitsThese are explained in greater detail below.The RSI was invented by Welles Wilder. It measures the average momentum of the market overa set period. The clever part of Wilder’s invention is that it is a weighted indicator. The methodof calculation means that it differentiates between a 5 day fall at the top of the market and a 5day fall at the bottom of the market.
fig 10.1You can see from the chart that the RSI oscillates between a broad upper level and a broad lowerlevel, with infrequent incursions beyond those levels. The market or security is said to beoverbought when the RSI reaches extremely high readings, and oversold when it producesextremely low readings.162
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What is meant by overbought/oversold?
The main thing that the RSI tells you is that the market’s momentum is unsustainable. There isa clear relationship between time and price. If prices advance or decline at an unreasonably highpace, a pause becomes inevitable. Why is it inevitable?In HG Well’s Food of the Gods, two scientists observe that nothing in nature grows at a regularand steady pace:“It was as if every living thing had to just accumulate force to grow, grewwith vigour for a time and then had to wait for a space before it could go ongrowing again.”The two scientists decide to eliminate the resting phase and to produce a substance which willdeliver only a growing phase. They feed chicks and a baby with a substance christened ‘Foodof the Gods’. The chickens grow to be the size of horses. The child turns out 18 feet tall, andlater 40 feet tall as an adult. It all ends in tears. Investors in technology stocks need not read the book.So as matter of observation one sees that the markets do have resting phases. There does notappear to be a reason why a market should not advance at a steady pace of 10 points per day forsay 20 days, an occurrence which would register an overbought reading near 100 on the RSI.But it does not do that. It is invariably the case that the market rushes upwards 150 points in thespace of just a few days, retreats a bit, rushes up again, pauses etc., just as the two scientists inFood of the Gods observed.There are several other momentum indicators, such as the overbought/oversold indicator, themomentum indicator and the market tracker. I do not suggest that the RSI is necessarily the best.It is simply the one that I use the most.It is worth reminding yourself that the RSI and other momentum indicators do not tell youanything about value. They do not suggest that the market is overpriced or underpriced. It mayindeed be overpriced because the momentum of buying has caused the market to overshoot‘true value’. But the RSI does not tell you that. It merely records the fact of overshot momentum.Settings
The standard setting for the RSI on many web sites is 14 days, but I prefer a 5 or a 9 day period.I’m not sure it matters much which period you use. The RSI always oscillates between 0 and100. For a shorter period like a 5 day RSI, a higher reading is required in order to be satisfiedthat the market has reached an overbought position when compared with a longer period like a14 day RSI. As you soon as you see the RSI on a computer screen, you will see what I mean.With a 14 day RSI the upper level which indicates that the market is overbought is 70 and thelower band which indicates it is oversold is 30. With a 5 day RSI the upper level is at least 80and the lower level at least 20.
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I make the following classification for the 5 day RSI: Any reading between 80 and 88 isoverbought. A reading in excess of 88 is severely overbought. Any reading between 12 and 20is oversold. Any reading less than 12 is severely oversold.
A. The RSI tells you something newIn early September 2000, the FTSE 100 index was powering ahead. The swing chart waspositive, point & figure charts of the index, of sector indices and of leading stocks were allstrong. The FTSE had exceeded its Spring highs and was closing in fast on its all time highs.There was strong volume to accompany the price expansion. There was no apparent reason notto be long the market. Or so it seemed. The RSI told a different story entirely. On 31st Augustthe RSI reading on the FTSE was 89.2, severely overbought. By 4th September the RSI readingwas 94.8 - the most overbought the market had been for more than 3 years. It was an easydecision to exit the market at that point, waiting for it to pause.There was no knowing that prices would collapse, as they did, but it was a virtual certainty thatthey would retrace some of the gains that they had made. Within 3 days the market had fallen150 points, within 6 days the FTSE had given up over 430 points. The initial fall of 150 pointswas easy to anticipate. In fact September 2000 represented a secondary high of the 1982-1999bull market and prices have still not regained those levels.Likewise in late July 2002, the FTSE was more oversold on its weekly and monthly RSI than ithad been for the past 17 years. It was not difficult to predict a corrective rally in August.To my mind it is vital for a swing trader to have some sort of momentum oscillator as a guide.It is all too easy to be carried away by a market that apparently knows no bounds.
B. Significant market highs and lows are oftenmarked by extreme RSI readingsThe Dow
1996 The actual low of the year was made in January but the significant low was that of 14thJuly with an RSI reading of 7.6. The significant high of the year was 25th November which hadan RSI reading of 95.6.1997 The high of the year was 29th July with a reading of 87.1. The significant low of the yearwas after the Asian currency crash on 27th October with a reading of 10.2.1998 The significant high was 16th July which preceded the LTCM imbroglio and the Russiandebt default. There was a reading of 83.6. The lows of 1998 were marked by a reading of 6.9.2001 The high of the year was 20th May with a reading of 87.1. The low of the year was 20thSeptember with a reading of 3.1.164
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FTSE
1999 The high of the year (and all time high to date) on 30th December had a reading of 88.5.The significant low of the year was 21st September which had a reading of 15.8.2000 As noted above the high of the year was 4th September (94.8) and the significant low ofthe year was 16th April when the reading was 12.5.This seems very enlightening doesn’t it? Actually it is less useful than might be supposed. Youwill see from an RSI chart that there are several occasions during the year when an overboughtor oversold condition appears in the markets. So whilst it is true that most significant turningpoints in the market are marked by overbought and oversold readings, not every extreme readingmarks a significant turning point. But two propositions can be derived:• Every time there is an overbought or oversold reading on the RSI, you shouldconsider the possibility that a major turning point has been reached.• When there is not an overbought or oversold reading (or there has not been onewithin the last 10 days or so - see the concept of divergence below), it is unlikely thatthe market has made a major high or low, although there is a small risk that it hasdone so.Extreme RSI readings fall into one of three main categories:(i) Beginning of move
Shortly after the trend has changed there is a surge of buying/selling which results in the marketbeing overbought/oversold. This is not an indication to exit one’s position. It is simply areflection of the surge of money which accompanies a perceived change in trend. This is a vitalconcept to understand.A typical example occurred on 4th and 5th August 1998 when the 5 day RSI on the FTSEregistered oversold readings of 12 and 13. This was plainly a reflection of the desperation ofmarket participants to get out of the market following the Russian debt debacle. It was notsuggestive of the end of a move, and indeed the FTSE carried on nearly 1000 points lower. Theclue that this was not the end of a move was not hard to find. The FTSE had made new all timehighs on the 19th July 1998. It had then given a sell signal. It was inconceivable that the marketwas signalling just a few days later that the new downtrend had already come to an end.A variation on this category involves no change in trend. After a long sideways move (theresting phase in Food of the Gods) a stock gives an established buy signal, and money surgesinto it as a new growth phase begins. Again the clue that this sort of overbought reading isnothing to worry about lies in the fact that it comes within days of the buy signal (or sell signal,as money surges out of a stock).165
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(ii) Clusters
*
*
*
*
*
fig 10.2Again 1998 affords a good example. On 2nd February 1998 the RSI reading was 91. The marketpaused for just over a week. By 12th February 1998 the RSI had fallen to 47 a neutral level. TheFTSE index however had fallen less than 1% to 5553 from 5599. The fact that the overboughtcondition had completely corrected itself without any substantial fall in the market was a cluethat the uptrend was not over.The FTSE continued upwards and by 20th February the RSI was 84 and the FTSE was 5752.On 19th March 1998 the FTSE again reached an overbought level. This time prices were 5998and the RSI was 87. This cluster of overbought readings was an important warning signal. Acluster of three overbought signals within 6 weeks was telling one that the market wasadvancing at an unsustainable pace.Finally on 5th April 1998 when the FTSE reached 6016 there was another overbought RSIsignal at 83. It was clear, and had been clear since 19th March, that the market was going to haveto pause. It traded sideways for the next 3 months.It was clusters of oversold signals in June and July 2002 which made me confident of a rally inAugust.
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(iii) End of move
There is no formulaic way of judging whether a single overbought/oversold reading hasoccurred in the middle of a move or whether the market is making a significant high or low atthe end of a move. One needs to use one's judgment. In broad terms once there has been a movelasting several months during which the FTSE has advanced or declined by more than 1000points, that is an indication that the market may have reached an end stage. What one is lookingfor is a combination of large price movement, over a significant period of time (not just a fewweeks) culminating in an overbought or oversold RSI reading. On 4th October 1998, the FTSE5 day RSI reached 13. There had been a 3 month move lasting over 1500 points and there wasevery reason to suppose that an important low was being made. The same happened on 21stSeptember 2001 when the Dow Jones recorded one of the lowest readings ever on RSI at 3.1.So even though matters looked very bleak after the terrorist attacks, the RSI was suggesting thata major turning point had been reached.
C. Taking profitsApart from the RSI readings which occur soon after a change in trend or soon after anestablished buy or sell signal, every RSI signal is suggestive of at least a pause in the market ora substantial bout of profit-taking or a market turning point.Except in the case of the RSI readings which occur soon after a change in trend or soon after anestablished buy or sell signal, I tend to take profits when I get a high (or low) RSI reading. Myrough rule of thumb is:
Reading
Mandate
80-84 or 16-20
Discretion to take profits
84.1-88 or 12-15.9
Mandatory to take half profits; discretion to take full profits
88+ or 11.9-
Mandatory to take full profits
Of course nothing is actually mandatory, but there would have to be a convincing reason, whichthere usually isn’t, to forbear taking profits with these sort of extreme RSI readings. Obeyingthis rule of thumb does involve missing out on the end of some juicy moves, but personally Ifind that no cause for lament. Swing trading is not a fishing contest. ‘The one that got away’ isa story that leaves me cold.
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Divergence as a signal to exitOne of the popular ways of using the RSI is to focus on the diminishing momentum of a moveeven as the market makes new highs or lows.
2
1
fig 10.3In September 1992, when the bull run in Barclays commenced, there were two readings of 85in the RSI but it was plain that this was a move that was just beginning. Those readings couldbe safely ignored.1.
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On 20th January 1993, one could hardly say that the move had just begun. Barclays hadbeen in an uptrend for 4 months. But on that day it registered an RSI reading of 84.5 asit closed at 397p. Could this be a major turning point? The answer was easy. The high ofthe day on the 20th January was 402p. The print at 400p triggered a powerful triple topbuy signal with a long tail. This was not the end of a move. It was the weight of moneyflowing into the stock at the start of a renewed upward move. The next day the marketclosed at 412p and the RSI reading was over 90, but again this could be ignored. By 26thJanuary the RSI reading was up to 95.6 when Barclays closed at 435p. A reading this highcould not be sustainable. I would have concluded that the market would have to pause. Idon’t know that I could have resisted taking at least half profits. A profit of 35p looksmeagre but 9% in 6 days works out to a healthy annual return. The market did pause for
RSI and Other Indicators
2 days, closing at 420p on 29th January with an RSI reading of 58. But having correctedthe overbought condition Barclays rocketed to 460p by 3rd February, a move which I’msure I would have missed in part. That peak at 460p did produce an interesting divergence.2.
Negative divergence occurs when the market price makes new highs but its momentum,as recorded by the RSI, diminishes. Once again the RSI is telling you something new. Themarket is losing its puff, despite the bullish appearance as it makes new highs. Barclaysmade new all time highs on 3rd February 1993 at 460p, but the RSI reading of 85 wasnowhere near the 95 recorded on 26th January when Barclays closed at 435p. That is saidto constitute negative divergence, because the RSI reading is not making a new high atthe same time that the share price is making a new high. You can see that on this occasionit worked because Barclays went sideways or down for several weeks.Market makeshigher high
RSI makeslower high
fig 10.4169
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One has to take care in using this tool. The momentum of a market cannot continue increasingindefinitely. Some might say that it is a statistical near certainty that the market will havenegative divergence at some point. It is true that while the momentum of an upward move maydiminish, that is to say the rate of advance may slow down, that does not necessarily foretell ahalt in the advance. The market may or may not pause. It may keep on going up with tinycorrections, generating a host of 50-75 readings on the RSI. Not too much emphasis should beplaced on divergence, but it is something that all technical analysts look out for, so you mightas well be on the same page.
Weekly RSII use a 5 week RSI chart. It is particularly valuable. It measures the market’s momentum over amedium term period. When the markets record extreme oversold or overbought readings, theywill often take many weeks to correct that condition which is worth bearing in mind as a swingtrader. One of the most frequent mistakes which traders make is to overweight the most recentprice movement in forming opinions about what will happen next. An outstanding example wasJuly 2002 when market commentators were forecasting Armageddon, but it was plain enoughfrom the weekly and monthly RSI charts that the downtrend was not going to continue in theshort-term. An upward correction or broad sideways movement was much more likely.Overbought and oversold readings occur infrequently on the weekly RSI. The readings can getmore extreme than on a daily indicator.Because the 5 week RSI is a weekly measure of overshot momentum, it follows that to correctthe condition, prices have to bounce/pullback over the week as a whole. One can be confidenttherefore that if prices move lower during the week, that move will probably not be sustained.A typical example would be Vodafone. On Friday 22nd February 2002, Vodafone’s daily RSIreading was 44, having been 11 just two days earlier, so it seemed as though it had corrected itsoversold condition. But its weekly RSI was 11.3. On Monday morning 25th February, Vodafoneopened up, but was immediately sold into and went down to its swing lows at 124.25p. This wasa move that was destined not to last and, sure enough, Vodafone bounced strongly the very nextday and the day after, and held most of its gains throughout the week, thereby correcting theweekly oversold condition.The primary use I make of the weekly RSI is as a filter to prevent me from establishing positionswhich are unlikely to be successful because the market is oversold or overbought.I do not initiate new short positions when the most recent weekly RSI reading is under 18, orlong positions when the latest weekly RSI reading is over 82.This is an extremely useful filter. To be clear: If I have an existing position and the weekly RSIreading is just under 20 or over 80, I will continue to run it, because it is possible for the RSI
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readings to get to over 90 or under 10. But to initiate a new long position when the market isoverbought or a new short position when it is oversold doesn’t seem sensible.But it is not an inflexible rule. For example, suppose that after a long upward run, the FTSEmade a high on a Friday which produced a mildly overbought reading (82) on the weekly RSI,and then suffered a strong bout of profit-taking, let’s say 300 points, during the course of 4consecutive down days between Monday and Thursday the following week. Assuming the selloff has not breached a swing low, the scene is set for a model swing chart buy signal if, onFriday, the market rallies through Thursday’s high. And it’s not going to be overbought by theclose that same day, unless it rallies about 250 points which would be a very happy event, andat which point one could bag one’s profits. So even though the previous Friday’s RSI readingwas overbought, it would not be a contraindication to acting on the buy signal I’ve described.
Other Indicators:A) Moving AveragesMoving averages are beguiling. When you look at a chart it is quite easy to see that, apart fromperiods when the market has an extended sideways move, a trend can be quite well defined bya moving average. But using modern software one can apply an optimiser to see how tradingwith a moving average works out, and you will often find the results disappointing. Weightedmoving averages work better. I do keep a series of front-end weighted long-term movingaverages (13 week and 25 week), mainly because the smoothing effect of the moving averagegives one some longer term perspective.So for example, after the lows on 21st September 2001, long term weighted moving averagesfell below the market as prices recovered and then as the recovery was sustained they startedrising. That suggested to me, and I made the point in Investors Chronicle, that one’s bias oughtto be to trade from the long side. That is not to say that short-term sell signals from the swingcharts or the point & figure charts should be ignored. That would represent a loss of discipline.It simply means I was more mistrustful of the short-term downtrends in that situation, more alertto move my stop loss down to or near the entry point as soon as possible, and quicker to takeprofits.One often hears technical analysts talk of a moving average providing support or resistance.Strictly speaking, this cannot be true. Support and resistance, being points where the marketconsensus is that prices are too cheap or too expensive, do not move in line with an average ofpast price action. But it is not an error, it is simply shorthand. It is a way of describing theanalyst’s assumption. He assumes that an established uptrend will continue, and if it is tocontinue it will not violate the relevant moving average. In that sense, the market ought not to171
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fall below a certain level, which, on the given assumption, is deemed to be a level of support.There are sophisticated trading strategies using moving averages. I don’t use such strategies, soI can’t speak with any authority about them.
B) The Coppock IndicatorAnother useful long-term indicator is the Coppock indicator. In the 1960s Edwin Coppocksought to devise an indicator which would avoid the ‘madness of crowds’. He bewailed theshort-termism of market sentiment. He consulted members of the Episcopalian church who toldhim that it takes between 11 and 14 months for human beings to adjust to bereavement or torecover from serious illness. Using this ‘fact’, he devised an indicator which would help signalstock market lows. I pause. Ridiculous isn’t it? Is it any surprise that many investors treattechnical analysts with deep suspicion?Ah, say