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Common Oscillators: RSI Today we will be talking about another common oscillator known as the RSI Common Oscillators: RSI

What is an Oscillator? Technical analysis indicator used to indicate short- term overbought and oversold conditions Examples: MACD RSI ROC Stochastic Oscillator Now to review, what is an oscillator? An oscillator is a technical analysis tool used to indicate short-term overbought and oversold conditions Examples include the MACD (which we reviewed previously), the RSI (which we will review today), ROC, the stochastic oscillator, but there are a whole range of other indicators available for technical analysis

Common Indicators (Review) MACD: moving average convergence- divergence Turns two trend-following indicators (moving averages) into momentum oscillator by subtracting longer MA from shorter MA Trend following Momentum Fluctuates around 0 line To review, the MACD is the moving average convergence- divergence indicator formed by subtracting the a longer MA reference with a shorter MA. This is one of the most common tools used for technical analysis as it allows one to follow trends, and track momentum. This calculation fluctuates around the 0 line.

Common Indicators RSI: relative strength index Measures speed and change of price movements Banded oscillator Between 0 and 100 Overbought when >70 Oversold when <30 Signals: divergences, failure swings, and centerline crossovers Today I will be going over the RSI, which is the relative strength index. The RSI is an oscillator that measures the speed and change of price movements by measuring the average gains over a certain period, divided by the average losses. It is a banded oscillator, which means that the value will only fluctuate between 0 and 100. The common read of this indicator is that a security is overbought when the RSI > 70 and oversold when RSI <30. Here is an example of an RSI graph you will see in a technical analysis chart. You can see the scale from 0-100 and bands at 30, 50, and 70. Signals of the RSI include divergences, failure swings, and centerline crossovers– among other things.

RSI- Example Here is an example of the graph of RSI with the accompanying price movement chart. You can see at the various points the RSI indicates potential overbought and oversold points. You can notice some correlations between the two graphs, but note that they are definitely not perfect. Notice that the bottom at the end of July evolved after the oversold reading. The stock did not bottom as soon as the oversold reading appeared. Bottoming can be a process so it is definitely not an exact science. From oversold levels, RSI moved above 70 in mid September to become overbought. Despite this overbought reading, the stock did not decline. Instead, the stock stalled for a couple weeks and then continued higher. Three more overbought readings occurred before the stock finally peaked in December (2). Momentum oscillators can become overbought (oversold) and remain so in a strong up (down) trend. The first three overbought readings foreshadowed consolidations. The fourth coincided with a significant peak.

RSI- Example Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range. In this chart, the stock is trading between 13.5 and 21 from April to September . The stock peaked soon after RSI reached 70 and bottomed soon after the stock reached 30.

RSI- Divergences Divergences signal a potential reversal point because directional momentum of RSI does not confirm price momentum. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum. 

RSI- Divergences Here is another example of RSI divergence. You can see that the RSI is showing a bearish signal as the RSI is forming a lower high while the security is forming a higher high. The result is a significant drop in price.

RSI- Centerline Crossover Use in conjunction with other methods - The Centerline Crossover is a less reliable signal of the RSI method so should be used in conjunction with other methods When RSI crosses above 50 line, it indicates that the market is making more highs and gains than lows and losses. The result is a bullish signal. Vice versa, when the RSI crosses below the 50 line, it is a bearish signal indicating that the market is making more losses than gains. Here is an example of using centerline crossover in conjunction with another method to confirm a trend.

RSI- Centerline Crossover Use in conjunction with other methods Here is an example of a heads and shoulders pattern. You can distinguish the two shoulders and the head, and draw the resulting neckline from trough to trough. Similarly in that time frame, you can see that the RSI makes a bearish crossover as the RSI sinks to below the 50 line.

RSI- Centerline Crossover Use in conjunction with other methods - This crossover of the RSI can be used to confirm the break below the neckline of the head and shoulders pattern and act as further confirmation of the break.

Bollinger Bands

What are Bollinger Bands? Bollinger bands is a trading tool developed in the 1980’s to graphically illustrate price volatility in a security.

How are Bollinger Bands Constructed? Bollinger Bands have three parts: 1) A middle line – This middle line is simply a moving average. 1) A middle line – This middle line is simply a moving average.

How are Bollinger Bands Constructed? Bollinger Bands have three parts: 2) An upper band – This upper band is typically 2 standard deviations above the middle line as determined using the same price data used to construct the middle line. 2) An upper band – This upper band is typically 2 standard deviations above the middle line as determined using the same price data used to construct the middle line.

How are Bollinger Bands Constructed? Bollinger Bands have three parts: 3) A lower band – This lower band is typically 2 standard deviations below the middle as determined using the same price data used to construct the middle line. 3) A lower band – This lower band is typically 2 standard deviations below the middle as determined using the same price data used to construct the middle line.

What is their purpose? Bollinger Bands can be used to identify: Expansion and Consolidation When a stock is volatile as compared to its normal price movement, the two bands will be relatively far apart. If the two bands are relatively far apart from each other, this signals expansion, and a trend may be in progress. When a stock is stable as compared to its normal price movement, the two bands will be relatively close together. If the two bands are relatively close together, this signal consolidation, as traders are still unsure about a stock.

What is their purpose? Bollinger Bands can be used to identify: Overbought and Oversold When stock prices persist to touch the upper band, a stock is thought to be overbought. If the upper band is said to represent a high price for the security, which we have just seen, then when a stock price continues to hit the upper band, it is being overbought (purchased by too many people for too high a price). This triggers a sell signal. When stock prices persist to touch the lower band, a stock is thought to be oversold. If the lower band is said to represent a low price for the security, which we have just seen, then when a stock price continues to hit the lower band, it is being oversold (sold by too many people for too low a price). This triggers a buy signal.

What is their purpose? Bollinger Bands can be used to identify: High Price and Low Price The middle line of the Bollinger Band indicator is a 20 day moving average. This line at any date represents the average price over the past 20 days. The upper band at any date represents a price that is two standard deviations above the average price over the past 20 days. In statistics, we accept anything at or outside two standard deviations of the mean to be at the very least a mild outlier. When applied to investing, and bollinger bands, whenever the price hits or exceeds the upper band, we could accept this price as being high. On the other hand, the lower band at any date represents a price that is two standard deviations below the average price over the past 20 days. As previously illustrated, whenever the price hits or falls below the lower band, we could accept this price as being low.

How can they be used in trading? Price targets Upper Price Target Upper bands and lower bands as price targets Buy signal when price deflects off lower band, crosses middle line Sell signal when price deflects off upper band, crosses middle line Uptrend when the bollinger bands are positively sloped, price is braced by the upper band and the middle line Downtrend when the bollinger bands are negatively sloped, price is braced by the lower band and the middle line Lower Price Target

How can they be used in trading? Buy and Sell signals SELL Signal Upper bands and lower bands as price targets Buy signal when price deflects off lower band, crosses middle line Sell signal when price deflects off upper band, crosses middle line Uptrend when the bollinger bands are positively sloped, price is braced by the upper band and the middle line Downtrend when the bollinger bands are negatively sloped, price is braced by the lower band and the middle line BUY Signal

How can they be used in trading? Uptrend and Downtrend Confirmation Uptrend Confirmation Downtrend Confirmation Upper bands and lower bands as price targets Buy signal when price deflects off lower band, crosses middle line Sell signal when price deflects off upper band, crosses middle line Uptrend when the bollinger bands are positively sloped, price is braced by the upper band and the middle line Downtrend when the bollinger bands are negatively sloped, price is braced by the lower band and the middle line

How to use them in your trading Access them on any trading program or platform in the same location as moving averages. Wall Street Standards – 20 day MA, 2 SD Note that many different time periods and sd values should be tried to see what works best for that particular security, and for your investment horizon (how often you want to buy/sell) Used with one or more other indicators for confirmation (trend lines and volume work well)

Bloomberg Tutorial RSI Bollinger Bands

Villanova Technical Analysis Group TAG