22)/14
=« G2 1 * 1 3)+E22)/ l 4
=ABS(F22/G22)
= I 00-( I 00/( I +H22»
21
13.82. I S
=823-B22
=B23-B22
=IF(OR(C23<0,C23=0),ABS(C23),0)
=«F22* 13)+023)/ 14
=« 022* 13)+E23)/ l 4
=ABS(F23/G23)
22
1 382.22
=B24-B23
=B24-B23
=IF(OR(C24<0,C24=0),ABS(C24),0)
=«F23* 13)+024)/1 4
=« G23* 13)+E24)/ l 4
=ABS(F24/G24)
= I 00-( I 00/( I +H24»
23
1 382. 1 2
=B2S-B24
=B2S-824
=IF(OR(C2S<0,C2S=0),ABS(C2S),0)
=« F24* 13)+02S)/ l 4
=« G24* 13)+E2S)/ l 4
=ABS(F2SIG2S)
= I 00-( I 00/( I +H2S»
To build a 3 period RSI eliminate lines 3, 4, 5, 6, 7, 8, 9, 1 0, 1 1 , 12, 1 3
>=Q.
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9
Use these formulas to construct a 1 4 period RSI
"C"C
= I 00-( I 00/( I +H 1 6»
1 00-( 1 00/(1 +H 1 7»
= I 00-( I 00/( I +H23»
96
Appendix B
TREND DETERMINATION- A QUICK, AcCURATE & EFFECTIVE METHODOLOGY
By John Hayden
This short article was written for my clients and friends in the spring of2000. Itis included here to help those that are interested in understanding how the RSI can beincorporated into an overall trading strategy. I have modified it to eliminate any redun­dancy with the majority of this book.It is my belief that it is a valid indicator that will work in all markets and all timeframes. The RSI can be used for:1 . Trend Analysis
2. Determining Price Objectives
After reading and studying the material within this book you should have athrough understanding of the RSI. At this point we will broaden our examination of someother momentum based indicators.Momentum derived oscillators are very popular among futures traders and havebecome increasingly popular among stock traders.The first momentum indicator measures the change in the closing price over'N' units of time. This indicator is referred to as the Momentum Indicator and it mea­sures the absolute change in price by calculating(Present Price)-(Price 'N' Time Periods Ago)The second momentum indicator is called the Rate of Change Indicator, whichmeasures relative change by the formula,(Present Price)/(Price 'N' Time Periods Ago)The third momentum-derived oscillator is the Stochastic Indicator developed byGeorge Lane. This indicator measures the relationship between the closing price andthe high and low price for the time period under consideration. The formula is[(Present Closing Price - Lowest Low 'N' Time Periods Ago)/(Highest High 'N'Time Periods Ago - Lowest Low 'N' Time Periods Ago)] * 1 00
97
This formula is a more involved than the simple Momentum Indicator formula.The fourth momentum-derived oscillator is the Relative Strength Index (RSI),which we have described in depth.With the flrst three oscillators, Momentum, Rate of Change, and Stochastic, amajor problem occurs when large price movements are dropped from the calculationduring the time period under consideration. This causes the indicator to oscillate morefrequently and with an larger amplitude than it should.For example, here is a chart of the March 2000 Silver contract where we lookat two consecutive days for the Rate of Change and Momentum indicators.D1�
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In early October, Silver had a large one-day advance (A) at C l . When the 9period Rate of Change or Momentum Indicator is calculated, the calculation is basedupon the closing price at (C I a) with the current closing price at (C I). The next day(C2), shows a closing price that is barely changed from (C I). However when thecalculations are redone using the closing price of (A) and the closing price of (C2), thelarge up move is dropped and the value of the Rate of Change and the MomentumIndicator makes a large move as measured by (E) while the price at (C I & C2) havebarely changed! This problem can also be observed in conjunction with the large downmove (B).98
Observe what happens when we change the look back period to 1 0 days. Im­mediately, we notice that the large moves at (A) and (B) are still included in the lookback that is calculated on the second day.Si lv$r - COMEXHar<::h a ooo10 p.n.:.t!l
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As shown by the chart, the amount that the oscillator changed (E) and (F) ismuch less when the look back period is extended to 1 0 days because the oscillator forboth days is looking at the price before the large move. The oscillators continue to dropat (F), where in the 9-day look back, the oscillators actually increased in value. It isinteresting that the price of silver actually dropped a tenth of a cent on this day! This isa major problem when using these simple momentum oscillators.
99
Because of its construction, the RSI dampens or smoothes these distortions.Here are the same charts with a 9-day and 1 0-day look back period of the RSI.8il_ - 00ItDJIIiUCIl 2000lUll: ' , 10
The vertical distance the RSI value moves (E 1 vs. E2) and (F 1 vs. F2) remainsbasically the same if the large moves are included or not included. This allows us toplace more significance on the actual values of the RSI. The Relative Strength Index isalways contained within a vertical range that runs from 0 to 1 00. This saves us thetrouble of constantly referring to past indicator values when determining overbought oroversold levels. This problem occurs because typical momentum indicators values arenot contained within a predefined vertical range.When discussing the RSI, most books on technical analysis typically use a 1 4-day lookback period for their calculation. It should be noted that a longer look back period makesa less sensitive RSI oscillation. When a smaller look back period is used, the amplitudeof the oscillation increases. I prefer to use a look back period of 1 4 days or time periods.This look back works best in all time frames and is one half the lunar cycle for daily data.
100
For intra-day time frames, some traders use a 9-period look back. In gold,silver, crude oil and the financial markets, a 25-day look back period performs well.There seems to be a 50-day cycle in these markets and a 25-day look back is half thecycle length. It is important to realize that the Relative Strength Index formula requiresat least 90 time periods of data to provide valid results. Otherwise, the formula will notyield accurate results for trend analysis. When I look at daily charts, I prefer to have atleast 200 days of data to trust the validity of the RSI data.An important fact to remember is that any oscillator, the RSI included, willbecome either overbought (bull market) or oversold (bear market) in a strongly trendingmarket. Consequently, the momentum indicator or oscillator will remain oversold oroverbought for quite a while.DETERMINING THE RSI RANGE
An up trending market will typically find support at the RSI value 40 with effec­tive resistance at the RSI value 80. A down trending market will find resistance at RSIvalue 60 with effective support at RSI value 20. Often, a primary indication that thetrend has shifted from bearish to a possible bull market occurs when the RSI that previ­ously respected the 60 level rallies up to an RSI value of 70 or higher. When the inevi­table decline occurs, the RSI will respect the RSI value 40 before rallying again.In an 80/40 range (bull market), you will see the RSI make higher highs andhigher bottoms, which is a classic indication of a bull market! Similarly, in a 60/20 range(bear market), you will see the RSI making lower lows and lower tops. Recognizing thisRSI behavior is very useful when looking at a futures or stock chart. Inspecting therange that the RSI is moving in provides the first clue that indicates the trend direction.The RSI finds resistance or support at previous tops and/or bottoms in the RSI valuesthemselves. Old resistance points can become new resistance points and if broken,become a new support level upon a retracement. Old support levels can prove to beeffective support again and, if broken, prove to be effective resistance.
101
Here is a longer term Japanese Yen chart:
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At (A) there is a small bearish divergence indicating that the prior uptrend isabout to take a detour. Prices decline to (B) where the market finds support at the RSI40 level. The rally to (C) is the first hint that a trend change could be coming, as the RSI60 level proves to be effective resistance. The decline in prices to (D) violates theprevious support line at 40. At this point, it becomes apparent that what should havebeen support has failed. RSI value 60 was effective resistance at (C) and these twoelements combined point to the fact that the trend has probably changed. The pricerallies a bit after (D) before faltering and declining to a new low. However, the RSIvalue fails to make a new low. Instead, it makes a bullish divergence! At this point, wecan safely say that the previous bull market has died! Our opinion is strengthened withthe RSI level of 60 at (C) proving to be resistance and the 40 level failing to providesupport in the decline from (C) to (D) plus a bullish divergence. The point where theBulls got excited about the bullish divergence is where we should be looking for a placeto get short!The rally to (E) respects the RSI 60 level before dropping to (F). However, theRSI does find some support at (F). This indicates that the Bulls might be preparing torally prices. When the rally falters at (G), we can safely assume that the bear market is102
still in effect. The low at (H) was not followed by a bullish divergence, which is a minorindication that a trend change could be coming. This was confirmed to some degree at(I) when the RSI managed to rally above 60 to 64.93 before dropping back. Our suspi­cions became more valid as the decline to (1) found support at the RSI 40 level. Thiswas similar to the RSI fmding resistance at the 60 level at (C). The rally to (K) violatedthe RSI 60 resistance level. The decline at (L) which found support at the RSI 60 levelconfirmed that we were back in a bull market. In fact, just as we were looking for aplace to get short the market prior to (E), we should now be looking for a place to getlong prior to (L). Remember, the RSI tends to find support (L) at old resistance levels(C, E, G, H) in a bull market.In any case, the rally to (M) met resistance at the RSI 80 level. The subsequentdecline to (N) found support at the RSI 60 level. Notice that this is the second time thatthe RSI 60 level has acted as support. This behavior by the RSI indicates that we are ina strong bull market. This would be similar to the RSI 40 level acting as resistance in abear market. In fact, after the bear decline to (D), the market rallied a bit finding resis­tance at the 40 level six days later (a six-period bullish divergence).Following the rally from (N), there was a bearish divergence at (0), followed byanother divergence a few days later. The decline in prices to (P) was followed by awarning that the trend could be changing, which came at (Q) as the RSI found resis­tance at the 60 level with a small bearish divergence that led to a decline to (R). Theexplosive rally to (S) provided a strong indication that the bull market was still alive andwell.It is interesting to note that (S) is a longer-term bearish divergence against (0).The first indication by the RSI that the bull market in Yen has ended will be the 60 levelacting as resistance followed by a violation ofthe 40 level - or the price negating the 40support level without first encountering resistance at the 60 leveLDETERMINING SUPPORT & RESISTANCE LEVELS
It is important to look for support and resistance levels on both the price and RSIcharts. I look at the RSI chart to determine at what price and at what level the RSIfound effective resistance and support. In an up trending market, the charts reveal thatcurrent support levels were former resistance levels on the price and RSI chart duringprevious days and weeks. In a down trending market, the charts reveal that the price orRSI values will eventually violate former support levels. As a result, these formersupport levels were transformed into current resistance levels by the down trendingmarket behavior.
103
LOOKING FOR A DIVERGENCE
A very significant clue that the trend is changing occurs whe� a divergence ispresent. A possible bullish divergence occurs when the price makes a new low, but themomentum oscillator fails to also make a new low. It becomes a valid bullish divergencewhen the price turns up from the low and the oscillator also turns up. A possible bearishdivergence occurs when price makes a new high, but the RSI fails to make a new high.It becomes a valid bearish divergence when the price drops.I hinted at this in the above section. What I am about to say next will shocktraditional traders. Whenever I see a bearish divergence, I immediately start to thinkthat we are in a BULL market. Whenever I see a bullish divergence, I start to think thatwe are in a BEAR market! I know that this flies in the face of what the textbooks say.Remember, as traders, we want to detect the moment the market might change itsdirection. The important point is that in the majority ofthe cases, my claim is very true.You will find repeated bearish divergences only in an uptrending market. Simi­larly, bullish divergences will only repeatedly occur in a bearish market. If you find thishard to accept, find a chart (weekly, daily) of the Japanese Yen, and start looking atwhat the RSI did from July 7, 1 995 to July 7, 1 998. You will be hard pressed to find abearish divergence in the daily chart and there is no bearish divergence in the weeklychart! Detecting a divergence is one of my favorite tools.This next chart displays how stock prices and futures prices behave the same.Notice how the 80/40 RSI levels were respected by multiple bearish divergences, but nobullish divergences ! The CISCO stock experienced multiple Bearish Divergences andthe price continued to rally. Bearish Divergence usually occurs in a BULL MARKET!
104
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Think of a divergence as a detour. The overall trend will resume once theprice gets past this temporary resistance or support area. Divergences are alwaysassociated with momentum-based indicators and typically shows up at the mo­mentum high or low. For example when a bull market is overbought, there will bea correction. Before the correction, there will be a loss of market momentum.When a bearish divergence occurs, the market is telling you that it is overboughtor overextended. When this occurs, you might want to take partial profits on yourlong position, because prices could be preparing to take a detour! Remember thatthe bearish divergence that occurs during the bull market is not telling you to getshort!
105
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A divergence takes a certain number of days to form. The strength of adivergence is based on the length of the formation time period. Calculate theperiod of a divergence as follows: the above Cisco stock chart prices have beenadvancing into late April (A), making a high close at 'x'. The price and RSI areboth making new highs (A). For the next 8 days, both price and RSI drop withneither going higher than the previous value at 'x'. Following this decline, bothprice and RSI reverse direction and rally for four days. At the close of the fourthday of this short rally, the price is higher than it was 12 days earlier at 'x'. But,the RSI is still lower than its previous peak. Consequently, there may be 12-daydivergence during the 2nd week of May.106
At this time, it is a possible or 'tentative divergence' because to become a'locked in divergence,' the price has to drop. It is the dropping price that will prevent theRSI value from exceeding 'x' , and will "hook" the RSI over or turn the RSI value down,making the divergence real. It is important to remember that until the RSI value actuallydrops under its previous value, this remains a 'tentative divergence' because the RSIvalue could exceed the 'x' value if prices continue up negating the divergence. Thismeans that we must wait one day or one period of time to confirm a valid divergenceaccording to the definition.Our next example (B) shows a 4-period divergence. The duration of a diver­gence is important. A two to six day divergence usually indicates that a detour in priceis more likely than a longer period. A longer divergence period of weeks and evenmonths, ifusing daily charts, is usually less indicative that a price detour is coming. Themost powerful divergence occurs during a 2 or 3 period divergence. In the overallcontext ofRSI applications as a trading tool, the divergence signals are relatively minor.I enjoy using divergence to detect what the overall trend is. Divergence is very useful indeciding where to take partial profits in multiple contract positions.USING MOVING AVERAGES
Another tool that I use to indicate trend is moving averages. This is the stan­dard workhorse tool used by most technical traders. Moving averages are valuablebecause they remove the volatility from the data series. For example, calculating amoving average based on the RSI effectively removes the volatility from the RSI calcu­lation and yields a smoother signal. In fact, the trend can be confirmed by calculating a9-period simple moving average (SMA) and a 45-period weighted moving average(WMA) on the RSI and price. When the:1.2.3.
4.
The 9-period on price is above the 45-period on price, andthe 9-period on RSI is above the 45-period on RSI the trend is up.The 9-period on price is below the 45-period on price, andthe 9-period on RSI is below the 45-period on RSI the trend is down.The 9 period on price is above the 45 period on price, andthe 9-period on RSI is below the 45-period on RSI the trend issideways to up.The 9-period on price is below the 45-period on price, andthe 9-period on RSI is above the 45-period on RSI the trend issideways to down.
107
Since the RSI is more volatile than price, the 9-period simple moving average(SMA) of the RSI will cross its respective 45-period weighted moving average (WMA)before the 9-period moving average (SMA) on price will cross its respective 45-periodmoving average (WMA). I place more emphasis on the moving averages based onprice than those based on RSI. By remaining aware of what the moving averages aredoing will help you to stay focused on the overall trend. When I am talking to anothertrader, I will often say that the moving average on price is positive. This implies that theshort-term 9-period SMA is above the longer-term 45-period WMA. The largest movesfrequently occur when both moving averages are moving in the same direction.One more thought on moving averages. You will fmd that the 45-period weightedmoving average (WMA) will prove to be support or resistance on price and the RSI.For example, you will often see a bull market retrace to its respective 45-period weightedmoving average in price and/or RSI. When this is observed it is another sign of what thetrend actually is.Here is an example of the U.S Treasury 30-Year Treasury Bond:
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108
From looking at this chart, it is obvious that the trend had been down since thebeginning of 1 999. However, by applying the previously discussed rules, we can see thefollowing. At ( 1 ) with the close at: 124" 14, the price found resistance at the 45-periodmoving average (the red line). Also, notice that the 9-period moving average (the greenline) on the RSI crossed under the 45-period moving average resuming the downtrend.At point (2) ( 1 22"09), the trend changed to 'sideways to down' preventing us fromlooking for a place to get long. Instead, it forced us to look for a place to get short.This became obvious at point (3) ( 1 20"04), where the trend went back to 'down. 'The trend shifted back to ' sideways to up' at point (4) ( 1 1 4"20). After the rally to (A),many traders began to believe that the price would continue higher. At (A), severalthings occurred. First, the trend was up, as the moving average on price and the RSIwere positive. Second, the RSI was unable to overcome the RSI 60-resistance level.Third, the price is not able to distance itselffrom the 45-period moving average on price.This is indicating that the probable direction ofprice would remain down. Moreover, thedecline into early August showed that the RSI broke possible support at 40, indicatingprobable lower prices.At (6) (111 "03), the trend turned down again. Between points 5 (114"26)and 6 (111 "03), the moving average went positive and negative a couple times.However, notice that the RSI continued to respect the 60-resistance level and themoving average on price continued to be negative. Then, at point (6) (111 "03),the trend resumed its downward trend. At point (7) (103"19), the trend brieflywent 'sideways to down. ' This was a false move because the RSI was findingresistance at the RSI 40 level. The fact that the RSI 40 level had acted as supportin late August was also significant Remember that in a bear market, what wassupport will often become resistance on a subsequent rally. This was signifyingthe probability of a major downward move in price.
In conclusion, the questions that I ask myself when determining trend are:1 . What is the RSI range?2. Has there been a range shift?3. Is the market respecting its former support and resistance areas?4. Is the market violating support and resistance areas and reversing theirroles?5. Have prices broken important trendlines in the price or RSI chart?6. What type of divergence is present?7. What is my moving averages showing me?
109
This quick checklist is how I can accurately and quickly detennine the trend. My bookT he 21 Irrefutable Truths of Trading A Traders Guide To Developing A Mind To Win(McGraw-Hill, 2000) provides more in-depth technical analysis methodologies to deter­mine trend, when to enter and exit a trade and the psychological characteristics thatsuccessful traders possess. You can order this book at Traders Press, Inc., PO Box6206, Greenville, SC 29606 - http://www.traderspress.com - 800-927-8222 - 864-2980222 - fax 864-298-022 1 .-
110
Appendix C
Examples oflonger term charts:.... �-
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113
Appendix D
John Hayden lives in Samara, Russia and is easily contacted by email:j hayden@FirstVolgaInvestments.com.
His website is: www.FirstVolgalnvestments.com.
The charts used in this book were created with EpsiionCharting. This is a chartingprogram that Mr. Hayden is developing for professional traders.
114
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