(originally posted 7/19/2011)
One of the most widely used ideas that Andrew developed on the RSI some 20 years ago is the bull and bear ranges. This idea is based on a security having a different character depending on when it is in a bull move or a bear move. We all know this happens, but to spot it early is the key. The normal range for RSI is said to be 30-70 which works OK if you know how to use it, but Andrew saw a shift when markets changed character. So it made since to adjust up the range to 40-80 in bull runs and down to 20-60 in bear runs. Once you are aware of it, the range shifts are easy to see on many RSI charts like the one below.
I chose a chart with some volatility to illustrate these shifts. MSFT has moved up and down for the last two years giving many range shifts for us to look at.
I have market all the range shifts with horizontal lines colored in green for shift to bull and red for shift to bear so you can see this concept at work on one of my RSI templates. There are a couple of shifts that could almost be called whipsaws, but if the trade was managed right you should have been able to extract some money with this knowledge alone. This is just with the textbook ranges. I also marked an important pattern that we will come back to on this chart in another post that way we can see how it played out real-time. As with all technical formulas you will get spikes and overshoots so some interpretation will be necessary, but the critical 40 and 60 levels should not be breached for long without shifting your ranges. I have marked two such spikes on the chart. You will also certainly get some securities that just don’t respect technical patterns so remember this is part of analysis, not a trading system.
Now all of that you can get from www.stockcharts.com in their RSI section as well as other sources; so let’s go a little further and see how we can anticipate a shift. You should definitely use this in conjunction with other indicators and price positioning taking a weight of the evidence approach if you are going to try and anticipate a shift. The key is to watch the opposite barrier of the range you are in for early warning. That means in a Bull range you should not only be watching 40 on the downside, but keep a close eye on 60 when it moves up. In a bull range when RSI has trouble rebounding over 60 after a pullback, the trend is getting tired and could be ready to reverse. The opposite will hold true for a bear range. Of course, there will be times you get both price and RSI will not reverse but move sideways with RSI oscillating between 40-60. This muddling is more likely when price is in a box or triangle type formation; but often the tired trend that cannot get RSI back above 60 after a run will be in the process of a reversal. I would consider this a modified failure swing. Let’s look at the same chart with the old lines marked in grey and the new line marked in red and green.
As you can see it sped up every signal improved entries and exits. You can also use all the signals as entries long or short and use other trade management tools to take you out of the trade (which I might suggest). In a couple of cases on this chart the entries were substantially better if you anticipated the shift. Now be sure that trying to anticipate does increase the risk of a failed move, but the point that you know you are wrong is closer as well. The age old dilemma in trading: get in earlier, take on more risk and more potential reward or wait for confirmation, have a higher winning percentage and capture less of the move. It is all about Style on that one.
You can see that as we start to peel back the layers of the RSI, it is not just another indicator that gives overbought and oversold signals. Today we learned one way to use it as a trend identifier. Now that we know how to identify the trend, the next installment in the series will show you how to tell when a trend is about to accelerate in either direction using RSI. Stay tuned.
Good Luck, it is there for the making!
(All market data above are derived from Stockcharts.com, Esignal, and Reutersdatalink)
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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