Indicators (Part 1)

If you look at a stock chart displayed on a trader’s trading terminal, you are most likely to see lines running all over the chart. These lines are called the ‘Technical Indicators’. A technical indicator helps a trader analyze the price movement of a security.

Indicators are independent trading systems introduced to the world by successful traders. Indicators are built on preset logic using which traders can supplement their technical study (candlesticks, volumes, S&R) to arrive at a trading decision. Indicators help in buying, selling, confirming trends, and sometimes predicting trends.

Indicators are of two types, namely leading and lagging.  A leading indicator leads the price, meaning it usually signals the occurrence of a reversal or a new trend in advance. While this sounds interesting, you should note, not all leading indicators are accurate. Leading indicators are notorious for giving false signals. Therefore, the trader should be highly alert while using leading indicators. In fact, the efficiency of using leading indicators increases with trading experience.

A majority of leading indicators are called oscillators as they oscillate within a bounded range. Typically an oscillator oscillates between two extreme values – for example, 0 to 100. Based on the oscillator’s reading (for example 55, 70 etc.) the trading interpretation varies.

On the other hand, a lagging indicator lags the price; meaning it usually signals the occurrence of a reversal or a new trend after it has occurred.  You may think, what would be the use of getting a signal after the event has occurred? Well, it is better late than never. One of the most popular lagging indicators is the moving averages.

You might be wondering if the moving average is an indicator in itself, why we discussed it even before we discussed the indicators formally. The reason is that moving averages is a core concept on its own. It finds its application within several indicators such as RSI, MACD, Stochastic etc. Hence, for this reason, we discussed moving average as a standalone topic.

Before we further understand individual indicators, I think it is a good idea to understand what momentum means. Momentum is the rate at which the price changes. For example, if the stock price is Rs.100 today and it moves to Rs.105 the next day, and Rs.115, the day after, we say the momentum is high as the stock price has changed by 15% in just 3 days. However, if the same 15% change happened over to let us say 3 months, we can conclude the momentum is low. So the more rapidly the price changes, the higher the momentum.

14.1 – Relative Strength Index

Relative strength Index or just RSI, is a prevalent indicator developed by J.Welles Wilder. RSI is a leading momentum indicator which helps in identifying a trend reversal. RSI indicator oscillates between 0 and 100 and based on the latest indicator reading, the expectations on the markets are set.

The term “Relative Strength Index” can be a bit misleading as it does not compare the relative strength of two securities, but instead shows the internal strength of the security. RSI is the most popular leading indicator, which gives out the strongest signals during the periods of sideways and non-trending ranges.

Let us understand this indicator with the help of the following example:

Assume the stock is trading at 99 on day 0, with this in perspective; consider the following data points:

In the above table, points gained/lost denote the number of points gained/lost concerning the previous day close. For example, if today’s close is 104 and yesterday’s close was 100, points gained would be 4 and points lost would be 0. Similarly, if today’s close was 104 and the previous day’s close was 107, the points gained would be 0 and points lost would be 3. Please note that the loses are computed as positive values.

We have used 14 data points for the calculation, the default period setting in the charting software. This is also called the ‘look-back period’. If you are analyzing hourly charts, the default period is 14 hours, and if you are analyzing daily charts, the default period is 14 days.

The first step is to calculate ‘RS’ also called the RSI factor. As you can see in the formula, RS is the ratio of average points gained by the average points lost.

Average Points Gained = 29/14

= 2.07

Average Points Lost = 10/14

= 0.714

RS = 2.07/0.714

= 2.8991

Plugging in the value of RS in RSI formula,

= 100 – [100/ (1+2.8991)]

= 100 – [100/3.8991]

= 100 – 25.6469

RSI = 74.3531

As you can see, the RSI calculation is fairly simple. The objective of using RSI is to help the trader identify oversold and overbought price areas. Overbought implies that the stock’s positive momentum is so high that it may not be sustainable for long, and hence there could be a correction. Likewise, an oversold position indicates that the negative momentum is high, leading to a possible reversal.

To begin with, the red line below the price chart indicates the 14 periods RSI. If you notice the RSI’s scale, you will realize it’s upper bound to 100, and lower bound to 0. However, 100 and 0 are not visible in the chart.

When the RSI reading is between 30 and 0, the security is supposed to be oversold and ready for an upward correction. When the security reading is between 70 and 100, the security is supposed to be heavily bought and is ready for a downward correction.

The first vertical line marked from left shows a level where RSI is below 30; in fact, RSI is 26.8. Hence RSI suggests that the stock is oversold. In this particular example, the RSI value of 26.8, also coincides with a bullish engulfing pattern. This gives the trader a double confirmation to go long! Needless to say, both volumes and S&R should also conform to this.

The second vertical line points to a level where the RSI turns 81, a value which is considered overbought. Hence, if not for looking at shorting opportunities, the trader should be careful in his decision to buy the stock. Again, if you notice the candles, they form a bearish engulfing pattern. A bearish engulfing pattern, backed by an RSI of 81 is a sign to short the stock. What follows this is a quick and a short correction in the stock.

The example that I have shown here is quite nice, meaning both the candlestick pattern and RSI perfectly align to confirm the same event’s occurrence. This may not always be true. This leads us to another interesting way to interpret RSI. Imagine the following two scenarios:

Scenario 1) A stock which is in a continuous uptrend (remember the uptrend can last from few days to few years) the RSI will remain stuck in the overbought region for a long time, and this is because the RSI is upper bound to 100. It cannot go beyond 100. Invariably the trader would be looking at shorting opportunities, but the stock, on the other hand, will be in a different orbit. Example – Eicher Motors Limited, the stock has generated a return of close to 100% year on year.

Scenario 2) A stock that is in a continuous downtrend, the RSI will be stuck in the oversold region since it is lower bound to 0. It cannot go beyond 0. In this case, the trader will be looking at buying opportunities, but the stock will be going down lower. Example – Suzlon Energy, the stock has generated a return of negative 34% year on year.

This leads us to interpret RSI in many different ways besides the classical interpretation (which we discussed earlier)

1. If the RSI is fixed in an overbought region for a prolonged period, look for buying opportunities instead of shorting. The RSI stays in the overbought region for a prolonged period because of an excess positive momentum.
2. If the RSI is fixed in an oversold region for a prolonged period, look for selling opportunities rather than buying. RSI stays in the oversold region for a prolonged period because of an excess negative momentum
3. If the RSI value starts moving away from the oversold value after a prolonged period, look for buying opportunities. For example, the RSI moves above 30 after a long time may mean that the stock may have bottomed out, hence a case of going long.
4. If the RSI value starts moving away from the overbought value after a prolonged period, look for selling opportunities. For example, RSI moving below 70 after a long time. This means the stock may have topped out, hence a case for shorting.

14.2 – One last note

None of the parameters used while analyzing RSI should be treated with rigidity. For example, J.Welles Wilder opted to use a lookback period of 14 days simply because that was the value which gave the best results considering the market conditions in 1978 (which is when RSI was introduced to the world). You may choose to use 5,10,20, or even 100 days look back period if you wish too. In fact, this is how you develop your edge as a trader. You need to analyze what works for you and adopt the same. Please note, the fewer the days you use to calculate the RSI, the more volatile the indicator would be.

Also, J.Welles Wilder decided to use 0-30 to indicate oversold regions and 70-100 level to indicate the overbought region. Again this is not set in stone; you can arrive at your own combination.

I personally prefer to use 0-20 level and 80-100 to identify oversold and overbought regions respectively. I use this along with the classical 14 days look back period.

Of course, I urge you to explore the parameters that work for you. In fact, this is how you would eventually develop as a successful trader.

Finally, do remember RSI is not used often as a standalone indicator by traders; it is used along with other candlestick patterns and indicators to study the market.

Key takeaways from this chapter

1. Indicators are independent trading systems developed and introduced by successful traders.
2. Indicators are leading or lagging. Leading indicators signal the possible occurrence of an event. Lagging indicators, on the other hand, confirms an ongoing trend.
3. RSI is a momentum oscillator which oscillates between 0 and 100 level
4. A value between 0 and 30 is considered oversold. Hence the trader should look at buying opportunities.
5. A value between 70 and 100 is considered overbought. Hence the trader should look at selling opportunities.
6. If the RSI value is fixed in a region for a prolonged period, it indicates excess momentum. Hence, instead of taking a reversed position, the trader can consider initiating a trade in the same direction.