A typical method of choosing which periodicity (i.e whether five days, ten days, etc.) to use would be to calculate from historic figures a periodicity that would have generated reliable signals. The choice is crucial, as shown by Figure 4.5 which adds a ten-day oscillator to the graphs already presented in Figure 4.4.
The terms over-boughtand over-soldare often used in conjunction with oscillators. A share whose oscillator has moved into the top of its normal range could be called over-bought, and vice versa. An alternative rendition is that when the oscillator forms a peak or V by itself, wherever it is in the range, it is indicating these conditions. And, emphasising the oscillator’s secondary status, the view is sometimes taken that it is neither peaks and Vs, nor extremities, that make signals, but rather occasions when the oscillator fails to replicate the basic patterns of the share price graph.
The momentum oscillator idea brings out one of the differences in philosophy between pure fundamentalists and chartists. Any share making a significant transition in value does so on a ‘two steps forward, one backward’ path. The fundamentalist isn’t interested in the fact that a share headed up from 100p to 200p will pause at 160p or fall back to 140p.
A pure chartist, unattuned to the brighter fundamental prospects for the same share, would likely find his oscillator in or close to over-bought territory all the way up to 200p, and would in any case be unlikely to receive an over-sold, or buy signal. However, the same animal works well for heavily cyclical shares.
-30 -20 -10 0 10 20 30 40 50 60 70 80
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
5-day oscillator share price
-50 -40 -30 -20 -10 0 10 20 30 40 50
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 10-day oscillator
Buy Sell
Signals from five-day oscillator
Buy Sell
Signals from ten-day oscillator Both: Buy at 30p
5-day: Sell at 50p 10-day: Sell at 70p
day
Figure 4.5 The effect of periodicity
To formulate a secondary indicator from changes in the share price, you need to decide its periodicity, or how many days’ worth of changes to use, e.g. last three days, last 25 days. To illustrate the effects of changing this input, the two graphs below show the different signals generated by a five-day oscillator and a ten-day oscillator. Note that in practice, you would not rely solely upon the oscillator’s signals and you might use a different rule to identify signals from that used here (which is ‘change of direction within the extremity’).
Despite the similarity in name, Welles Wilder’s RSI is absolutely nothing to do with ‘relative strength’ discussed on pages 78–79. RSI is a sophisticated oscillator, measuring the current strength of the share price against its own recent history. Relative strength (often known as the share price relative) measures the strength of the share price against the strength of other comparable shares. Some chartists term Welles Wilder’s RSI, rate of change(or ROC) to distinguish it from relative strength.
RSI compares recent rises with recent falls and works out which tendency (rises or falls) is dominating, and by how much. It’s simpler than it sounds, but nevertheless ingenious. The formulation is set out in the table in Figure 4.6, and Figure 4.7 shows how it looks on a chart.
In this example, the averages of rises and falls are calculated over the previous ten days. Welles Wilder in fact recommended using 14-day averages, but as always, this is a ‘what works best?’ situation. Many modern adherents of RSI use shorter periods, sometimes as little as five days.
Unlike the momentum oscillator, RSI always fits into a predetermined range of 0 to 100. This is achieved by the indexing adjustment, which is what happens in the last column in Figure 4.6. This means its extremities (the levels above and below which it is over-sold or over-bought) can be predetermined too, whereas with the oscillator you have to identify what the range is in order to judge where the extremities lie. It is pretty much an iron rule that over-bought and over-sold, when using Welles Wilder’s RSI, are set at 70 and 30 respectively, which are the figures he proposed.
Occasionally chartists use 80 and 20.
Relative Relative Strength Strength Index Ratio of
10-day 10-day average 100 – (100/
Trading average average rises to [1+ relative
Day Price Rise Fall of rises of falls average falls strength])
0 140
1 142 2
2 140 2
3 139 1
4 137 2
5 139 2
6 141 2
7 143 2
8 142 1
9 144 2
10 146 2 1.2 0.6 2 66.7
11 148 2 1.2 0.6 2 66.7
12 149 1 1.3 0.4 3.3 76.5
13 149 1.3 0.3 4.3 81.3
14 150 1 1.4 0.1 14 93.3
15 150 1.2 0.1 12 92.3
16 150 1 0.1 10 90.9
17 148 2 0.8 0.3 2.7 72.7
18 146 2 0.8 0.4 2 66.7
19 144 2 0.6 0.6 1 50
Figure 4.6 Calculating Welles Wilder’s RSI
A great strength of RSI, as compared with a momentum oscillator, is that it does not react with a jerk when a previous step-change in the share price falls out of the reckoning (see Note 4 in Figure 4.4). The three most popular rules for generating trading signals from RSI are:
● reversals within over-extended territory
● RSI crossing from over-extended to neutral territory. This rule would have generated trades at the points marked xin Figure 4.7
● divergences or failure swings(Figure 4.8).
0 20 40 60 80 100 160
10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
‘over-bought
‘ ’
under 30 (some users,u s under u 20) = ‘ ’
R S I share price 120p
140p
Whereas a momentum oscillator typically maps out peaks and ‘Vs’, Welles Wilder’s
valleys: it more time of ‘ ’.
are ways to for
some successful is a reversal of RSI back a recent
level) within or territory. In this case, RSI gives more signals, and Note that, like a momentum oscillator, RSI is generally used as a secondary indicator, with the chartist looking it confirm some other feature in the data, such as a double
share divergences the share price and RSI
patterns, before acting its signals.
RSI reverses in over-bought territory : ‘SELL’
RSI reverses in over-sold territory : ‘BUY’
sell
buy x
x x
RSI Sell
RSI Buy RSI Buy
-30 -20 -10 0 10 20 30 30
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85
MOMENTUM OSCILLATOR RSI
ten-day momentum
oscillator
Figure 4.7 Relative strength indicator (RSI)
Just as with other indicators, RSI does not work well if a long-running up or down trend is in place. This can be seen in Figure 4.8. Welles Wilder himself suggested that it was best used in sideways trending (or trendless) markets.
0 20 40 60 80 100
5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 day
160p
120p 140p
Successful RSI signal:g
‘BEARISH DIVERGENCE’
high, to it...
‘Look out – ’
under 30 over 70
uccessful RSI signals:g
Once the trend is established, RSI fails to
read it (or ‘ ’). RSI
over-sold and gives false, reversal signals
RSI share price
Figure 4.8 RSI (like everything else) isn’t always right