(Originally posted 7/23/2011)
This post is part of a multipart series. If you wish to start at the beginning go to Taking RSI to the Next Level
Among the many nuances that Andrew extracted from the RSI in his research, the one I think that defines the effort the best would have to be positive and negative reversals. These signals contribute to my analysis in three distinct ways. They act as entry signals, give a way to measure trend strength, and can provide a warning signal. We will go over each of these uses once we learn how they are formed. Let’s use the WFC chart for this first example because it is sporting both signals over the last year. I have labeled the signals in red and green lines, and have fully marked up the first positive reversal on the chart to show construction and the target.
A positive reversal could be described as the opposite of a positive divergence. With a positive divergence it comes at the highs of a move in an uptrend and you have a lower price with a higher RSI. To make sure we are only concentrating on the reversal signals right now, I have cleaned most everything else off the charts in this exercise. As you can see in the WFC chart a positive reversal shows up in a pullback during an uptrend where the chart has a lower RSI with a higher price when the pullback reverses. The negative reversal in the RSI is just the opposite. Negative reversals form during the bounces in a downtrend. This works off the same concept as Can the MACD Identify a Counter-Trend Move? (posted on blfgria.com) where the velocity of the momentum indicator is disproportionately faster than price movement in a counter trend move. With the RSI this indicator movement allows for these reversal patterns to form. So we can see how the positive reversals are formed; now lets look at how their targets are measured and how to use them. As you can see on the left side of the WFC chart we have a positive reversal that has fired and now is moving higher. I have labeled the X and Reference point on the chart as well as the intervening high. Close values are used for all points in the calculation. While many use these targets as a place to take profits, Andrew teaches that these targets have value in trend analysis as well. In trend analysis it can play the important role of confirming the strength of the trend in a couple of different ways, but first we have to know how to measure the target. You calculate this by taking the difference in the close price of the reference period minus the X period and then add that to the highest high close intervening. If a positive reversal exceeds its target the trend is considered strong. When the signal fails to meet its target it is a big clue of a potential reversal of the trend. I’ll save that for a little later, let’s start with using these signals for entry signals.
The positive and negative reversals give good entry signals on a pullback during a move. How often are we looking at a chart that we missed the kickoff move and/or is in an accelerating trend and we are having a tough time finding a place to get in? These signals give good entry points long for positive reversals and short for negative reversals. The first two charts show some very good entry signals in up trends.
The EP chart has been a very strong mover over the last year. One unusual thing about this chart is the first positive reversal comes before an official range shift which is pretty rare. I have not seen enough of them to say if they can give us an extra edge in our trading. EP has been firing signals all the way up, even in March when a breakdown looked in the offing; RSI held at the 40 level and formed a positive reversal showing the bulls were still in control. Most of the reference points would have been pretty solid entries for swing and position traders. A couple took a while to kick in or had slight drawdowns before continuing, but that is trading.
Everyone who even sniffs the markets knows NFLX has been in a monster trend, and many of those observers are chomping it the bit to short this one. As you can see on the chart, the trend never turned down, so if you were shorting you better be quick and nimble. The most hope the bears had here was a quick spike down in March that turned out to be nothing more than a bear trap that didn’t even close the preceding gap really frustrating the bears.
And on the downside:
BRCM has been in a downtrend this year, along the way RSI users were given many chances to short the rips and bank some pretty good gains even at times the overall market was rallying. At this point BRCM is very close to causing the final negative reversal signal to fail which would go along with the resurgence in Semiconductors we started to see this week and signal a possible trend change.
I also used GOOG in the downtrend category, but actually this chart is giving us both signals. However, in March GOOG gave us a good entry point at the first negative reversal which broke down shortly there after.
As usual patterns to the downside are considerably quicker and more volatile to work with. Shorting is not for the undisciplined or the faint of heart. These signals can be powerful especially when they come right after a range shift and at other support and resistance points reinforcing the importance of the price zone.
I t is always comforting to see postives fire on a chart, but if the positive reversal comes soon after a range shift from a bear range to a bull range it helps confirm the trend change as well as gives a good pullback entry with a very high success rate. The MCD chart below shows us a positive reversal right after the range has shifted which is one of the best trend confirmations and solidifies that the bulls are holding the reigns tightly.
As the trend continues we see positive reversals forming after many of the pullbacks affirming the trend each step of the way. As long as they are firing and meeting targets the trend is up. Once a failed pattern appears, we should take notice
Failed patterns can be as important as those that succeed, especially after a long run up or down. Late stage positive and negative reversal patterns are not as reliable as those in early stages so key on the failures for this early warning. I have marked these failed patterns in many of the charts we have already seen. These patterns often precede a trend change, but can be successful warnings without ruining a chart. In LULU chart you can see we have two failed positive reversals that do lead to a fairly quick retreat in the chart, but the strength in the underlying bid soon reappeared and the trend resumed. Price action always overrules indicator signals.
This is to drive home the point that all analysis has a time when it doesn’t work in a textbook fashion. That is why they still need us, because a good portion of technical analysis still falls under interpretation due to the many factors that drive an individuals analysis. If it weren’t that way then computers would do all the trading (not just 70% of it as we see now). But that is a topic for some other time.
Today we isolated the positive and negative reversal signals so that we could concentrate on how they work and what they can tell us on their own, but most good technicians will not rely on one measurement. If you combine this with what we learned in the last two pieces you can see how RSI is becoming a much more multifaceted toolkit. In the next post I will go over divergences and why we all might be using them wrong.
Good Luck, it is there for the making!
(All market data above are derived from Stockcharts.com, Esignal, and Reutersdatalink)
BLFG is not affiliated with Cardwell Financial Group.
There is no guarantee that the views expressed in this communication will become reality. Investing in the stock market involves risk and potential loss of principal, Investment strategies should be thoroughly researched and understood before implementing and none of this should be construed as a recommendation