This Popular Indicator Can Be Improved Upon

Traders might disagree on whether a stock should be bought or sold. They might disagree on the name of the pattern they spot on the chart. But, one thing they do seem to agree on is that indicators should be added to charts because these tools are useful.

The price chart depicts the price action and traders have been searching for patterns on the charts since at least the early 1900s. By the 1940s, many traders had added moving averages which were designed to highlight the trend. Then, they began adding indicators to charts as shown below.

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  • This is a chart of the SPDR S&P 500 ETF (NYSE: SPY) with RSI at the bottom. RSI is the relative strength index.

    RSI is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.

    Investopedia notes:

    “The relative strength index (RSI) is calculated using the following formula:

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  • RSI = 100 – 100 / (1 + RS)

    Where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame

    The RSI provides a relative evaluation of the strength of a security’s recent price performance, thus making it a momentum indicator. RSI values range from 0 to 100. The default time frame for comparing up periods to down periods is 14, as in 14 trading days.

    Traditional interpretation and usage of the RSI is that RSI values of 70 or above indicate that a security is becoming overbought or overvalued, and therefore, may be primed for a trend reversal or corrective pullback in price.

    An RSI reading of 30 or below is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.”

    RSI was introduced to traders by J. Welles Wilder in his 1979 book, New Concepts in Technical Trading Systems.

    Improving on RSI

    Wilder was a futures trader. His book actually focuses on the futures markets and ignores individual stocks but his concepts have been widely adopted by traders in the stock markets. His focus on the futures markets, however, explains why he chose 14 days as the default parameter.

    In the futures market at that time, traders often noticed a cycle in prices that repeated about every four weeks. This cycle was also about the length of the time in the lunar cycle. Traders attributed the cycle in prices to the effect of the lunar cycle on crop production.

    Wilder believed that using 14 days would be about half the time of the lunar cycle and allow him to identify significant points in the price action that were tied to this cycle.

    One could argue there isn’t a 28 day cycle in agriculture or price action and even if there were, the cycle is in calendar days and RSI uses 14 trading days which is different. With 28 calendar days in a cycle, there are about 13 cycles per year. With 14 trading days there are about 18 cycles in a calendar year.

    This simple review of the formula demonstrates that there is not a rigid requirement to use 14 days in the calculation because that value is not the result of a detailed and rigorous scientific analysis. That means we could benefit from changing the period used in the calculation of RSI.

    RSI(2) Could Be Useful

    One variant of RSI was developed by Larry Connors. As explains,

    “…the 2 period RSI (or RSI(2)) strategy is a mean-reversion trading strategy designed to buy or sell securities after a corrective period. The strategy is rather simple. Connors suggests looking for buying opportunities when 2 period RSI moves below 10, which is considered deeply oversold.

    Conversely, traders can look for short-selling opportunities when 2-period RSI moves above 90. This is a rather aggressive short-term strategy designed to participate in an ongoing trend. It is not designed to identify major tops or bottoms. “

    The chart below shows an example of RSI(2) at the bottom of the chart. The traditional calculation using 14 days is shown in the center of the chart.

    In this chart, the overbought level is shown at 80 and the oversold level is set to 20. Connors has also used these values in testing and found them to be useful. There are more trading opportunities with the lower values.

    You may notice in the chart that there are frequent trading opportunities with RSI(2) while it is rare to see a signal with the 14 day calculation. This indicates the default value of 14 days may not be the most useful for traders.

    Connors has also written about using a 5 day calculation, RSI(5), and he has applied his strategies to both daily and weekly time frames. This work demonstrates the flexibility of RSI. It also throws into question the value of the traditional calculation, especially in the stock market.

    This work also demonstrates that it will be difficult for traders to find success with indicators using default parameters. They may find more success with less traditional approaches, simply tweaking the calculations of existing indicators in pursuit of a trading edge.

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