that fade the current move.9. The real battle in the market place is between traders of different beliefs andtime perspectives.10. The one universal difference in beliefs is over what timeframe is the mostadvantageous to trade in. However, the larger the capitalization the longerthis timeframe must be.1 1 . The largest struggle is which timeframe has the most accurate infonnationconcerning future events.1 2. There is no "reality" of the market place - prices can and will behave in themost unexpected manner.
43
John Hayden
1 3 . Price itself is nothing more than a number with the only semblance to realitybeing that one buyer and seller have agreed upon a price in an instant of time.One or both of these traders might have been under duress in making thetransaction.14. In order to trade effectively, we must identify not only which force (Bulls orBears) are stronger, but also what timeframe is the dominant timeframe. Ifthis dominant timeframe requires more capitalization than we have, we musthave an alternative trading strategy that will enable us to enter the trade orstand aside.1 5 . One of the best "off the shelf' indicators that reveals the dominant timeframeis the Relative Strength Index.1 6. By examining the price action in whatever timeframe you prefer, you can seethat there are certain price patterns (not bar patterns like triangles, pennants,etc) that repeat semi-randomly and only occasionally fail.1 7. As we shall see, when we combine these price patterns with an understand­ing of retracement theory and RSI analysis, we can have a high probab�lity ofcreating trading profits.1 8. Fibonacci numbers, when divided into preceding Fibonacci numbers, willgenerate decimal products (or ratios) that quickly approach equilibrium. Theseratios are used in retracement theory.19. Retracement Theory tells us the strength of the current trend, indicates priceswhere we may enter or add to a position, and once the previous peak/troughis exceeded, these retracement levels may be used for our stop placement.
44
SECTION IIUSING RETRACEMENT THEORY TO TRADE
CHAPTER !
CONVENTIONAL USES OF THE RELATIVE STRENGTH INDEXBefore continuing, here is a brief review of the published literature regardinghow to conventionally use the Relative Strength Index. This infonnation is importantbecause it serves to highlight the reasons why so many people fail to make money intrading. Since most of the published literature has little value, it serves us to show uswhat NOT to do or believe in. In this section, my comments are indented.When Welles Wilder introduced the RSI, he recommended using a 1 4-periodlook-back when using daily data. The RSI is actually a momentum indicator that followsthe price activity of an underlying security. Because of the structure of the fonnula, theRSI value is contained between a minimum value of 0 and a maximum value of 1 00.The RSI fonnula was developed almost 30 years ago. As a result, certain beliefs havedeveloped over the years as to how to best use this versatile -indicator. Welles Wilderdescribed some of these beliefs in his original work and different traders through theircollective experience with the indicator have developed other beliefs. There are 9 basicbeliefs concerning the best way to use the RSI :1.
Indication o fTops and Bottoms2. Divergence3. Failure Swings4. Support and Resistance Levels5. RSI Chart Fonnations
45
John Hayden
6.7.8.9.
Altman Modified - Smoothed RSIMorris Modified RSIModification of Look Back PeriodModification of the Data Source Used
1.
Indication of Tops and Bottoms
In many cases, the RSI value will "top out" in the range above 70 and "bottomout" in the range below 30. RSI tops and bottoms often precede price tops andbottoms. The RSI begins making tops and bottoms before they become obviouson a price chart. Many traders use the 30 level as a buy zone and the 70 level asa sell zone. Some traders have modified these values to make the buy zone 20and the sell zone 80.In the past few years, this concept has been expanded. This method generatesa buy or sell signal only when the RSI leaves the zone. In other words, if theRSI is 73 on Monday, 7 1 on Tuesday, and 68 on Wednesday, Wednesday is nowa bearish indication, telling us to go short on the open Thursday. If the RSI in thelast bar is under 30, we would get an indication to buy when the current barcloses with the RSI rising above 30. This is now a bullish signal to get long onthe open of the next bar.The top and bottom levels recommended by Wilder are 70 and 30. However,there is published information that advises modifying these RSI levels if theprice is trending higher or lower. While some traders consider an RSI value of70 a sell signal, the number would be revised to 80 if prices were in an uptrend.If the prices are trending lower, the buy zone would be changed from an RSIvalue of 30 to 20.JH: Basing a trading methodology on this principal will only lead tolosses.2.
Divergence
This is the most popular use of the RSI. Bearish Divergence occurs when theRSI value fails to make a new high as the price is making a new high. A BullishDivergence occurs when a new low in price is made while the RSI value is notmaking a new low. The price action is diverging from the RSI action. When­ever price action is trending up and the RSI values are trending down, you areseeing a "Bearish Divergence." Whenever you see prices trending lower andthe RSI values trending higher, you are seeing a "Bullish Divergence."
46
RSI: The Complete Guide
When a divergence is encountered on a chart, the accepted belief is that areversal in price is imminent. Published literature also states that the most _powerful divergence occurs when many time periods or bars have elapsed.The time period number for these strong divergences is anywhere from 30 to 90bars.JH: Going long when a bullish divergence makes its appearance isa certain way to make small profits and generate large losses!3 . Failure Swings
This concept is actually a part of divergence. A failure swing occurs whenthere is either a bearish or bullish divergence. By looking at Chart #3, you canmore easily see a failure swing. As the price makes a new low, the RSI fails tomake a new low so a bullish divergence is formed. The next day prices rallycausing the RSI value to also rally. When the RSI value exceeds its previouspeak, it is called a "failure swing." It typically indicates that prices will continueto move higher. A failure swing with a bearish divergence is the same typeformation only the RSI moves lower than the previous trough. This is a failureswing down. The failure swing is believed to "confirm" that a market reversalis valid.JH: Afailure swing only confirms that the divergence is reaL Waitingto go long until a failure swing occurs after a divergence makes itsappearance is a sure way to make small profits and generate large.losses!CHART # 3
-
" 1' i I , I ! I , .
FAILURE SWING
111 1 I
�
Failure'" '-
Swing
47
'\\..
_ A
John Hayden
4 . Suppor t and Resistance levels
The RSI chart can be used to more clearly see support and resistance levels. Inaddition, many traders use the 50 level as support and/or resistance. When theRSI rallies from under 50 to above 50, it is considered a bullish confirmation.When the RSI crosses from above 50 to below 50, this is seen as bearish con­firmation.JH: It pays to notice when the RSI crosses 50, but this should not be ourmain focus while trading! We know that the RSI crosses the 50 level whenthe ratio of up days to down days averages reverse.5.
RSI Chart Formations
There are many times when RSI values make triangles, pennants, double topsand bottoms, or head and shoulders patterns that are not visible on a price chart.The RSI lends itself to the use of trendlines and horizontal support and resis­tance lines on the chart. The validity of these lines is the same as that on a pricechart.JH: This is absolutely true! The most common pattern is the triangleformation, which often indicates a pending explosive move. However,there is often a false breakout before the real move!6.
Altman Modified RSI (commonly caUed RMI)
Roger Altman modified the RSI formula to reflect more of a momentum aspect.He believed that the RSI oscillated inconsistently between overbought and over­sold levels. While the RSI calculates the change in gain/loss "bar to bar," Mr.Altman modified the formula to calculate the change from the "n'th" bar in thepast (where n is more than 1 ). This modification is referred to as the RMI orRelative Momentum Index. Some traders like it because it smoothes the zigzagappearance of the RSI. This defeats the purpose of using the RSI to obtain anearly indication of important price behaviors as it introduces time lag into thecalculation. When I want to smooth the RSI, I like to use a smoothing constantof3 with a look back period of l 4. The literature recommends using 7, 9, 1 4, or25 as a smoothing constant.JH: We will not use this method in creating trading rules. There is alot that can be done with this concept and it might be a good idea toexplore some variations once you understand the concepts in this book.By using a smoothing constant, we are introducing time lag into ouranalysis, which we do not wantfor the purposes ofthis book. However,once we learn about Momentum Discrepancy Reversal Points, RMI48
RSI: The Complete Guide
can be used as a jilter. By applying a smoothing constant of 3, manyof the more "jine" distinctions such as a 2-period Bear divergencewould be eliminated. The appearance of either a Momentum Discrep­ancy Reversal Point or divergence will have added significance andvalidity with the RML Once you have mastered the RSI, come back tothe RMI and compare its performance in real time versus the RSI. Isuspect that you may like what you jind.CHART # 4
-
COMPARISON OF RSI (BOTTOM) VS. RMI
(TOP - WITH A SMOOTHING CONSTANT OF 3)
49
-
John Hayden7.
Morris Modified RSI
This derivative of the Wilder RSI was introduced in the 1 998 Bonus issue ofStocks & Commodities Magazine. The Wilder formula uses an exponentialmoving average on the second bar after the look back period. The Morris RSIcontinues to calculate the average gain and average loss on the last "n" bars butit calculates the indicator with a simple moving average. Changing the calcula­tion in this way increases the volatility and generates more buy and sell' signalsbecause it crosses the 70 and 30 levels more frequently.JH: For the purposes of this book, we will not use this modified RSI.Perhaps the best use for this modified formula is in detecting hiddensignals. As the smoothing component of the RSI has been eliminated,the signal line will be much more ''jagged'' generating more hiddendivergence signals and Momentum Discrepancy Reversal Points andsimple bullish and bearish divergence.CHART # 5
-
COMPARISON OF MORRIS MODIFIED RSI (MIDDLE PANEL) VERSUS RSI(BOTTOM PANEL)
85.0015.0065.00
3:25
'SI17
10:15
10:55
1 1 :35
1 2: 1 5
1 2:55
1:35
2:15
2:55
,6i1 a
50
1 0:25
11 :05
11 :45
12:25
1 :05
1 :45
2:25
3:05
RSI: The Complete Guide8.
Modification of the Look-Back Period
By modifying the look-back period used in the RSI calculation, it is possible tomake the RSI more or less volatile. Decreasing the look-back period increasesthe RSI volatility while increasing the look-back period reduces the volatility. Asthe volatility changes, the RSI "the range" oftop and bottom value also changes.Some traders change the look-back period causing the RSI to oscillate within acertain band. Should the trader want the RSI value to be very sensitive to pricechange, then they want to use a shorter look-back period. Many traders use a 9and 25-bar look-back period plus a 1 4 period look-back.JH: The common reason to do this is to gain a perspective of a differ­ent timeframe. This is better accomplished by using a 14 period look­back RSI on charts that use different units of time.CHART # 6 - COMPARISON OF RSI (3 BAR LOOK-BACK) AND RSI (14 BAR LOOK-BACK)
" 86.01
100.00
51
John HaydenChart 6 Comments:
This chart illustrates how much easier the RSI 3 bar look back (middle panel) can bedriven to overbought or oversold levels.9.
Modification of the Data Source
Traders have also used the RSI formula by using the change in the open, high or lowprice rather than the closing price in the calculation. An alternative to using the closingprice is to apply a formula that manipulates the price in a certain way and applying theRSI formula to this synthetic number. Some of the price modifications are to determinethe average of the HighILow, Open/Close,Open Yesterday/Close Today or any otherIvariation of range.One of the more novel approaches is to determine the standard deviation of the closeover the previous 1 0 days and base the RSI upon how the standard deviation changeseach day. This variation is an alternative way to measure market strength.JH: I like this concept. It is an alternative and very effective way tomeasure market strength. However because the purpose of this bookis to gain a thorough understanding of the RSI, it will not be discussedfurther. Once you understand the concepts included in this book, takesome time to play with this idea. As you will see in Chart # 7 below,whenever the RSI modified value exceeds 70, the internal strength ofthe market is overextended. To use this indicator, it is easiest to thinkthat when the value is over 70, the "Duracell Bunny" has no energyleft to push prices higher or lower. For the "Duracell Bunny" to pushprices, he must retreat to under 40 to recharge his batteries!
52 2
RSI: The Complete GuideCHART # 7
-
RSI 14 PERIOD (MIDDLE PANEL) VERSUS RSI STANDARD DEVIATION(BOTTOM PANEL)
Summary of Published Literature
Unfortunately, if a trader relied on these commonly accepted methodologies totrade with the Relative Strength Index, he or she would probably lose all oftheir money!The most powerful ways to use the RSI are not even described in the published literature!
53
54
CHAPTER 2
PROFESSIONAL RSI USEAs discussed in the previous section, these are the nine widely known meth­ods to use the RSI:1.2.3.4.5.6.7.8.9.
Indication of Tops and BottomsDivergenceFailure SwingsSupport and Resistance LevelsRSI Chart FormationsAltman Modified - Smoothed RSIMorris Modified RSIModification of Look Back PeriodModification of the Data SourceIn the beginning of this book, I mentioned that we would use the RSI to
identify:1 . The current trend - if any.2. Best prices to enter or exit a trade.3. Price levels for probable retracement.4. The dominant timeframe.5. When a longer timeframe is negating or overpowering the present timeframe.6. Price objectives that have a high probability of success.I understand that many traders who are reading this book are probably con­fused, especially if they have studied the "conventional" uses of the RSI. The confusioncomes because I am telling you that using the RSI as an indicator of tops and bottoms"as described" is wrong. I have said that using the RSI for divergence recognition and55
John Hayden
order entry will generate losses and that using the RSI to indicate a bullish or bearishbias when the Rsi is above or below the 50 level will generate further loses. Thesestatements go against the "conventional" trading ideas that are associated with the inter­pretation of the RSI.In order to use any indicator correctly, a trader must thoroughly understand it.Once the indicator is understood, it must be accepted as it is. "It is what it is." Forexample, it doesn't matter that "everyone" is saying that tops occur at 70 and bottomsoccur at 30, if this rarely happens. Many traders when using an indicator get caught ina trap of thinking "could've, should've, would've." Traders who use conventional RSIknowledge are often frustrated because they believe that the market "should've" donethis because the RSI is doing "that."The 10 RSI Lies that Traders Believe:
1 . A bearish divergence is an indication that an uptrend is about to end2. A bullish divergence is an indication that a downtrend is about to end3. The RSI will generally "top out" somewhere around the 70 level. At thispoint, we want to start thinking of getting short or at the very least exiting longtrades.4. That the RSI will generally "bottom out" somewhere around the 30 level. Atthis point, we want to start thinking of getting long or at the very least exitingshort trades.5. Whenever the RSI is above 50, it is a bullish indication. Ifnot long, find anexcuse to get long.6. Whenever the RSI is below 50, it's a bearish indication. Ifnot short, fmd areason to get short.7. A failure swing is a significant event.8. The RSI is unable to indicate trend direction, because it's only a momentumindicator.9. The RSI is unable to indicate trend reversals, because it's only a momentumindicator.1 0. It is not possible to use the RSI to set price objectives.In this section, we are going to use everything covered in Section I to beginusing the RSI to consistently generate profits. The amount ofprofit and the consistencyof the profits are dependent upon the quality of your analysis and your psychologicalresources. If you are interested, I have written a book devoted to the best ways toincrease your psychological resources. It is entitled The 21 Irrefutable Truths ofTrading. By the end of this book, the quality of your analysis will have improved56
RSI: The Complete Guide
significantly and you will be able to determine the following without looking at the barson a price chaI1:1 . The current trend.2. When the current trend will probably retrace.3. When the current retracement is no longer a retracement but a trend reversal.4. The best time and price to enter or exit a trade.S. Support and resistance numbers for accurate stop placement.6. High probability price objectives helping to establish risk/reward parameters.7. When a longer timeframe or traders with more capitalization have entered themarketplace.
57
58
CHAPTER 3
TREND DETERMINATION VING RSIThe traders' eternal question of "What is the trend?" is easily answered whena trader knows how to interpret the RSI. A trend is supposed to be easy to describe, butfor many traders it is very difficult to identify in real time. Up trends are defined asprices making higher highs, and retracement lows or troughs are higher as well. Adowntrend is the inverse.Just as an uptrend, downtrend or sideways price action is visible on a pricechart, the same behavior can be seen on the RSI chart. You can see chart examples ofthe RSI making a higher top, retracing to make a low that does not exceed the previouslow, followed by a rally to a new high establishing the pattern of an uptrend.There are many times that the RSI will show an uptrend or downtrend that isnot obvious on the price chart. The chart below on the left will illustrate this concept. Itis a slice from a I S-minute chart of the E-Mini S&P on May 1 3, 2002. We can see thatthe RSI is making higher highs and higher lows. Looking at the price bars, it is easy tosee that prices are rising. However, it isn't so easy to see the market retracements.Clearly, the market is trending higher.
59
John Hayden
CHART # 8
-
1 5 MINUTE CHART & CHART # 9
-
1 MINUTE CHART E-MINI S&P
1060.00
10051.ooiI
1055.00
90,0080.00
.... I
��
Using this concept will identify the trend using the RSI in a timeframe that isshorter than the one you are studying. In the I 5-minute chart to the left, the price istrending up, but placing a trade based on this I 5-minute chart using the RSI would bedifficult because there is no clear place to buy unless you are using a breakout strategy.One of the problems with breakout strategies is that they often experience considerableprice slippage. Our goal is to enter our trades on limit orders when the market retracessome of the previous move. In this example, if we were I -minute timeframe tradersusing the I 5-minute chart for confirmation, we would be able to find multiple entry pointson the I -minute chart on the right. The I 5-minute chart on the left serves as a trendconfirmation tool.There is a better way to use the RSI. In the mathematical chapter of Section 1 ,we discussed how the ratio between the up average and the down average affects theRSI value. The RSI behaves like a logarithmic function. This causes the largest changesin the RSI value to occur when the up/down average stays in the range of ratios be­tween 1 :2 to 2 : 1 . This range of ratios corresponds to RSI values from 33.33 to 66.67.Do you recognize the Fibonacci number? It is in this band of values that we see thelargest movement of the RSI value versus change in price. This is why the conventionalknowledge states that tops typically occur around an RSI value of 70 and bottoms willoccur around 30.
60
RSI: The Complete Guide
Looking at any chart with the RSI, we can see multiple times when tops werearound 70 and bottoms were around 30. Within that overall chart picture, the pricebehavior may have been trending up, down, sideways or some combination. A very wellestablished fact is that markets can become very emotional causing prices to exceed a"fair" level before retracing. The RSI will also push too high or too low before retrac­ing.Chart # 1 0 demonstrates an up trending market that is being dominated by 5minute traders. The price and RSI are moving steadily higher. The retracements areclearly visible in both the RSI and price. The RSI value is easily exceeding the 70 leveland is staying well above the 30 level. Closer examination reveals that the RSI is stayingabove 40 once the trend begins.CHART # 10 - 5 MINUTE S&P E-MINI S/13/02-UPTREND
ES200208LA9T·5mln
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1 '.'.l'L · 1
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!
1056.00
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1054.00i
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8:25
8:55
8:25
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1 1 :25
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61
1 :25
1 :55
2:25
2:55
3:25
3:55
4:55
5:25
5:55
6:25
'500
35.00
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I
I
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!
John Hayden
Chart # I I shows a market that has started to trend lower being dominated by5-minute traders. The chart shows the RSI often falling below the RSI vl;llue of 30 andthat it is not exceeding the 70 level on rallies. Closer examination of the chart revealsthat the RSI is not getting over the 60 level and at times is having a hard time movingabove 40. This is a great indication that the market is going much lower.CHART # 11
-
5 MINUTE S&P E-MINI 6/25/02-DoWNTREND
1005.00
1000.00
995.00
99000
-985.00
70.00
6000
so 0040.00
30.00
5:50
6:20
6:50
1:20
7:50
8:20
8:50
9:20
9:50
10:20
1 0:50
" "20
1 1 :50
1 2"20
1 2:50
1:20
1:50
2:20
2:50
3"20
3.50
This chart reveals an interesting observation. In an uptrending market (Chart1 0), the RSI value does not go under the 33.33 level and often stays above the 40 levelwhile routinely exceeding the 70 level. In downtrends (Chart 1 1 ), the RSI doesn't goabove the 66.67 level and often stays under 60 while routinely going under the 33.33level. At this point, we can make a general observation that in an uptrend 33.33 issupport and 66.66 is resistance in a downtrend.Referring back to the ratio Table # 3 on page 1 0, once the up/down ratio climbsto 4 : 1 or I :4, the incremental increase or decrease of the RSI value has rapidly de­creased. We can observe that the majority of the RSI movement will fall within these62
RSI: The Complete Guide
boundaries. Significant mathematical resistance is encountered at an RSI value of 80and significant support is encountered at a value of 20. This is not exactly what every­one else says!As we can see in an uptrend, support is 33.33 - not 20. In a downtrend, resis­tance is 66.67 - not 80. By combining everything and knowing that prices and the RSIcan become "hysterical," we can come up with the following rules:Rule # 11 . In uptrends, the RSI will find support at 33.33 and resistance at 80.2. In downtrends, the RSI will find resistance at 66.67, and support at 20.Rule # 1 is illustrated in Charts # 10 and 1 1 .Careful examination of thousands of charts reveals that support in an uptrendingmarket is closer to 40 than to 33 and resistance in a down trending market is closer to 60than 67. However, these levels are only valid when the majority of traders in the mar­ketplace all are focusing on the same timeframe. If there are traders focused on adifferent timeframe, they may cause these significant levels to be momentarily negatedwithout destroying the trend.Using the 80/40 and 60/20 range rules, we can instantly identify the trend themajority of the time. If the RSI is staying within the 80/40 ranges, we know that thetrend is up, and the majority of the "other" traders are also looking at this same timeframe. If the RSI is staying within the 60/20 ranges, we know that the Bears are incontrol and the trend is down. Just understanding this one rule allows us to quicklydetermine the trend without looking at a price chart! Then, by adding our knowledge ofbasic retracement theory, we can confirm the RSI behavior by observing the depth ofthe retracements on the price bars. Should traders in a longer timeframe take interest inour timeframe, then the RSI levels will not be respected and we can expect to see deepretracements. RSI and price "behavior" will tell us if the preceding trend is still in effector if the trend has in all probability changed. Before we can discuss this price behavior,we must first understand some more RSI concepts. In Chart #4, the 40 level did notprove to be support as it was negated by a longer timeframe, but the bull market was stillintact.Rule # 1 - Modified1 . In an uptrend, the RSI finds resistance at 80 and support at 40.2. In a downtrend, the RSI finds resistance at 60 and support at 20.
63
John Hayden
CHART # 12
-
BULL MARKET WHERE 40 WAS NEGATED ANDBULL TREND REMAINED INTACT.324.0
OCM2LAST-10 mln ')Cil (i]l),,; V<-319.1 ,_8 -019'
315.0314.0313.0312.0311.0
64
CHAPTER 4
THE TRUTH ABOUT DIVERGENCEOne of the fIrst things that every trader learns early in his or her career is theconcept of divergence. Whenever divergence is discussed, it seems that the majority ofexamples used to illustrate the concept use the Relative Strength Index. Divergenceoccurs in any momentum-based indicator and occurs when price and an indicator aredoing different things, i.e., price is moving higher and the indicator is moving lower orvice versa. These types of divergence are classifIed as simple divergence. There arealso examples of multiple long-term divergence and hidden divergence.
CHART # 13
-
THE RISE OF INTEL - WHERE IS THE BULLISH DIVERGENCE?
Chart # 13 Note:
Don't worry about what a MDRP is for now. Focus on fInding the BullishDivergence in this bullish chart. There are none! We shall see that they only occur inbear markets, not bull markets!65
John HaydenLet's examine the concept behind a bullish divergence.
First. What is the price behavior doing just before a bullish divergence occurson a chart? Price is declining. As more traders realize that the price is headinglower, they are attempting to get short or exit their longs by selling. The majorityof these orders are "at the market," and the floor brokers and traders continueto lower their offers to buy since the majority of the order flow is "at the mar­ket." In other words, the sellers are hitting the buyers offer price causing thefloor traders who are buying to continually lower their bid. Each time a newtrade is executed the bid price drops.Second. The RSI very accurately reflects the change in the average gain orloss for a time period. As prices continue to fall, they very often begin toaccelerate lower.