MOMENTUM – INTERPRETING RSI – I

Linearity or trend in a price does not depict the strength and weakness cycles in a price very well. Momentum is a popular secondary indicator after price because it de trends the price and elucidates when the trend in a price strengthens and weakens. Why is this important? A stock or asset bought in a weakening or falling cycle may fail to move up despite all positive news behind it and vice versa. When a stock fails to behave as expected, the investor loses patience and conviction regarding his investment and throws in the towel. After which (to the investors consternation) the stock proceeds as expected. The only way to overcome this unfortunate feeling is by understanding cycles or simply putting market momentum.
The relative strength index (RSI) was developed by Wells Wilder. It is one of the post popular momentum indicator or oscillator that measures the relative strength of the price of a stock or market. How strong or how weak is the price? When is the cycle of strength higher and when does the price trend exhaust and fall?
Momentum falls in two broad categories, banded and non banded. Banded ones move in a fixed range, 0-100 for RSI and non banded move around a mean or equilibrium or zero line like ROC and MACD. Banded indicators are easier to interpret as they swing in a range and move from one extreme to other exhibiting a consistent periodicity.
[bold]RSI Interpretation[/bold]
Before we talk about the various ways to interpret RSI, one should understand that like every interpretation, momentum or RSI interpretation has a convention and unconventional usage. Therefore the trader should not only understand the conventional usage of indicators but also know how to use them unconventionally. Since indicator failure is a reality, a conventional interpretation has a high chance of failure. Some of the principal methods used to interpret the RSI are as follows.
[bold]1.Extreme Readings[/bold]
When RSI moves above the 70 level it can be considered as an overbought level or when it moves below the 30 level it can considered as an oversold level. These levels again depend on time frame under consideration and also on whether the market is trending or ranging. Overbought or oversold reading does not indicate a clear sell or buy signal but it only indicates some action in opposite direction is pending as market has a tendency to return to the mean in long run. Though we at Orpheus use the 30-70 default, traders also talk about stretching the limits to 20-80. Sometime extreme readings can also be established in terms of historical levels e.g. when was the last time RSI hit 90 on weekly basis or say 15 on a multiyear basis.
[bold]2.Concept of failure swings[/bold]
Failure swings, in overbought or oversold territory, signal that a trend is weakening and likely to reverse. A trough below the oversold level, followed by an intervening peak that does not reach the overbought level, then a higher second trough and to complete the failure swing the indicator must then rise above the intervening peak. The similar concept can be applied for movement from the overbought level to give a good sell signal. This the classic DOW Theory rules of lower highs and lower lows applied to the momentum indicator instead of the price. We have not seen failure swings as a commonly appearing phenomenon. They are a bit rare, hence more effective. Failure swings are defined above 70 and below 30 levels not between the 30-70 bands.
Mukul Pal
Orpheus Capitals, Global Alternative Research