3 Tricks for Harnessing Market Momentum

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Jan 22nd, 2013 | By | Category: Featured, Investor Education, Trend Playbook, Trends

You’ve seen that little graph before — you know, the small one above the technical price charts that we use — but what the heck does it mean?

Momentum… RSI… relative strength index… Whatever you want to call it, most investors just don’t get how to use it. That’s why today I want to show you three tricks that you can use to harness this powerful market tool to your benefit.

RSI has to be the technical tool that we get the most questions about from our Trend Playbook readers. Questions like this:

“You’ve mentioned relative strength several times in previous articles. I understand the concept of relative strength, but am confused on how to interpret the data on the RSI chart relative to what I’m seeing on the corresponding price trend charts. Have you written a recent article on this that you can refer me to?”

So let’s get right down to it. The RSI chart that this reader is talking about looks like this:

The relative strength index — better known as RSI — is a momentum indicator. It measures the strength of a stock’s moves on a scale from 0-100. The term “momentum” is a bit of a misnomer. If you think back to your high school physics class, momentum is something entirely different — instead, think of stock momentum like acceleration. It measures how fast a stock’s upward or downward movement is changing. (Math nerds can think of a stock’s momentum as the first derivative of its price.)

When a stock’s price is moving up too quickly, RSI can give you an overbought reading, and when it’s dropping too fast, it can show you that shares look oversold. The standard overbought and oversold levels are 70 and 30, respectively.
The formula for calculating RSI looks like this:

where RS = average gain/average loss

Thankfully, computers can calculate it automatically. In fact, it’s the default top indicator when you use a chart from StockCharts.com.

We regularly see three misconceptions about the relative strength index:

1. RSI Doesn’t Equal Relative Strength

Before we get into how to use RSI, I want to bust one of biggest confusions that investors have about this indicator: It’s not the same as relative strength.

I’ve talked about relative strength here before. It’s a measure of how a stock’s price is doing relative to the rest of the market. But as I just explained, that’s not what RSI is — instead, it’s more of a stock’s price performance relative to itself. Plenty of people confuse relative strength and the relative strength index, and I can’t blame them. The names are similar enough to cause plenty of confusion.

But that’s not the only mistake investors make when it comes to using RSI.

2. The “Defaults” Do Matter

One thing that makes RSI especially useful is that it can be customized. You can specify the time period over which it’s calculated, for instance (the default is 14 days). Or you can change the thresholds that qualify a stock as overbought or oversold.

But I wouldn’t bother.

Studies have shown that that vast majority of sophisticated investors never change their defaults on technical indicators. So it’s become the common wisdom that if you want an edge, you should tweak those parameters. While that makes sense on the surface, for most traders’ purposes, it’s a waste of time.

The time period you chose for RSI should be based on your trading time frame. Generally, you want to use a time frame that’s around half your ideal hold time. So as a swing trader (holding positions for around a month), a 14-day RSI is fine by me. Unless you’re generating black-and-white buy and sell signals with RSI (chances are you’re not), changing the time frame from 14 to 14.38 to 16 to 12 isn’t going to make much difference in how the line looks. So don’t waste mental energy optimizing it.

3. Overbought and Oversold Aren’t Really Overbought and Oversold

Another big mistake investors make with RSI is using an overbought or oversold reading as a reversal indicator. In fact, statistics show that a stock that is overbought on RSI is actually more likely to continue to increase in the short term than it is to reverse lower. That’s not something most investors realize.

Instead of looking to sell above 70 and buy below 30, you should view those extreme RSI readings as a signal that momentum is squarely in the direction of the reading. So a reading of 75 means that a stock has extremely bullish momentum and is more likely to be a buy than a sell.

When you’re analyzing RSI, you’ll get the most from looking at how the indicator trends in relation to the stock you’re looking at. You want uptrends in price to be paired with uptrends in RSI — that means the uptrend is continuing to gain steam and pull more buyers onboard. Since momentum is a leading indicator of price, a downtrending RSI line during an uptrend in price should be viewed as a big red flag. In technical parlance, that’s called a bearish divergence.

Putting RSI to work on your charts can give you a lot of context on a stock’s price. The big problem is that most investors just don’t know how to use it.

Keep these three misconceptions in mind when you’re looking at an RSI chart and you’ll be more likely to spot unnoticed opportunities in your trades.

Happy trading,
Jonas Elmerraji, CMT

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Jonas Elmerraji

Jonas Elmerraji, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes, and a contributor to Agora Financial’s Trend Playbook. Jonas got his start on the fundamental side of the market, poring over financial statements and valuations to find sound investments – today, he specializes in blending fundamental and technical analysis. Jonas is a senior contributor to TheStreet.com, and has been featured as an investment expert in Forbes, Investors Business Daily, and CNBC.com among others. 

Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

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