Pattern Recognition, Price And The RSI

Citation preview

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

Pattern Recognition, Price And The RSI by John Knaggs

Here's first-time S TOCKS & COMMODITIES contributor John Knaggs on combining price and relative strength index patterns for trading signals.

P

atterns can be found between price formations and such mathematical trading tools as the relative

strength index, the momentum oscillator developed by J. Welles Wilder Jr. Such price and indicator patterns, together with their variations, tend to repeat, allowing traders familiar with them to gauge the maturity of a given buy side or sell side price trend and thus recognize when the trend is peaking. This knowledge can help a trader stay with a price trend until the trend has run its course. It can then aid in generating a trading signal to either exit an established position or initiate a new one.

The relative strength index is used to ascertain overbought/oversold and divergent situations. Price declines have different forms, each with their own characteristic RSI pattern The relative strength index (RSI) plotted along with price is used to ascertain overbought/oversold and divergent situations. Price declines have many different forms, each with their own characteristic R SI pattern. The RSI as used here is calculated on a 14-day cycle, an interval I find to be most useful when the price trend is changing. The trading signal we will be watching for is characterized by these elements: 1 A downtrend in prices characterized by lower lows. 2 An uptrend in the RSI (divergence), which in turn creates a gradually rising support zone. The RSI probes this zone as prices make new lows.

Article Text

Copyright (c) Technical Analysis Inc.

1

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

3 Some buy side activity in price behavior that precedes our trading signal but does little more than run price to the upper region of its down channel. This results in an upward spike in the RSI, which helps us see the potential end of the price decline. We'll use this spike to help determine the timing for a potential trend-reversing trade. 4 The first consolidation of prices after they accelerate into the new trend. Figure 1 is a chart of December 1987 Treasury bonds for the period September 8 through October 19. Compare the price trend to the shallow, angled trendline drawn under the R SI for the same period. Note the price and RSI diverge. On October 13 the RSI spikes upward, with buy side prices well within the downside price channel. As the RSI gradually settles into its own rising support level, prices begin to fall to new lows. Studying price alone in this example as it makes new lows gives you little or no clue to the fact that prices have gathered support and are ready to reverse direction. A study of the RSI, however, shows that each successive marginal new low in closing price for the four days leading up to October 19 draws the RSI down closer to its own rising support level. This pattern hints that price support is accumulating and we can interpret it as a trading signal. TRADE TIMING Reading this trading signal requires close attention to intraday RSI behavior in the final days of a downside price trend. Now, let's study a few examples of downside events to get a sense of the trade timing as well as a dose of confidence. But first, let's look at one last element of this signal's pattern. As prices reverse direction and accelerate into a new trend, a group of traders holding short positions are forced to cover. Once this group is forced out, normally there is a consolidation for prices similar to that of October 28 through November 2 (Figure 1). Such a price consolidation can be used to add to an already established position or to establish a position within a price trend for which you have missed the initial trading signal. Is this a fluke formation? Compare the price trend for December 1987 T-bonds on April 24 through May 20 to the rising support line drawn under the RSI for the same period (Figure 2). Again, price and RSI diverge. Note the telltale one-day recovery of prices on May 18, which is well within the downward price channel. After this isolated upside spike in the RS1, the RSI settles into its own rising support zone. New price lows hint at a trading signal. Compare the two similar RSI formations in Figures 1 and 2, each clear examples of the RSI trading signal pattern. The price decline due to short covering on May 22-26, with a price consolidation of June 2-10, gives us another opportunity to get on board. Can you rely on such information for making trading decisions? Compare the price trend for September 1992 T-bonds on February 18 through March 16 to the support line drawn under the RSI for this same period (Figure 3). Again, we have the divergent quality of price and the RSI. This time, the buy side price spike on March 9 and 10 lasts for two days instead of one. Prices then slump to new lows, and the R SI settles gradually into its own rising support zone. Compare the character of the RSI spike and slide in this example to Figures 1 and 2. In Figure 3, the buy side price trend does not display the dramatic rally of our previous examples.

Article Text

Copyright (c) Technical Analysis Inc.

2

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

However, it does trace out a trading range for 21 days. The rally during the trading range was the longest in the bear market, and support held when the lows of March 16 were retested. This decline, which stopped short of making new lows, should have alerted you to another possible trading opportunity, once that becomes evident with the trend resumption after the consolidation of April 23 through May 5. PATTERN VARIATIONS How does this price and RSI pattern respond to a gradual price decline? Figure 4 shows the divergence pattern between the price trend of July 1983 lumber and RSI during the period of March 10 through April 5. Closing prices during this period are flat, while the RSI trend is rising. RSI displays its tattletale spike on March 23 as prices rise inside their downward channel. Prices then crawl their way down in a truly gradual decline. Between March 25 and April 5, the RSI looks as if it might be signaling a trade three separate times. Assume you were a buyer on the close of March 25 at $198.00. You would have had an unrealized loss of 24 ticks up to the time when support was actually reached, not a serious loss in the lumber market. Your stop-loss order should have been placed below the support level, effectively keeping you in the trade. The near-term low price of $195.60 on March 11 was tested again on April 6 and held. Prices then recovered to close that day at $196.90, which was a modest 11 ticks below your entry level. Even a nervous trader would have been able to survive the seven days between March 25 and April 5 until prices reached the support zone. In the price consolidation of April 19 through 27, the RSI pattern displays a spike on April 25 and then a short slide into rising support. This pattern should look familiar. At this point, you may have been somewhat unwilling to move quickly after having suffered through the last long-awaited trading signal, but hindsight proves that adding to your established position at this point was the correct thing to do. Figure 5, a chart of July 1986 lumber, is an example of a pattern not realized. Here, the R SI does not exhibit rising support, which was an important factor in the previous examples. From January 13 through February 5, both prices and the RSI make new lows . The trend reverses and prices rise on completion of the failure indicated by the price spike on February 34. The shallow downside day on February 5 should have alerted you to the developing reversal. To better understand this trading signal, let's go back to an earlier point on the chart, August 23, 1985. The closing price of February 5 is clearly lower than that of August 23. Examining the RSI on August 23 and February 5 reveals that it established a support zone at just about the 28 level on both occasions. It is not wise to get involved in price events that play out over this long a period, but when the RSI regularly finds support at a given level and no new fundamentals seem to affect the market, then those R SI levels become relevant. Look for price to find support as the RSI settles into its own support level. Gauging the validity of the trading signal then becomes a matter of deciding whether the RSI-price pattern has concluded. After a price consolidation of February 23-24, an aggressive resumption of the upward price trend follows. STOP-LOSS MANAGEMENT Establishing a stop-loss point is a balancing act with two primary functions: First, to help you stay in a trade as long as the trade is performing or has the potential to do so. Second, to help you exit the trade if it either violates the trading parameters you set or goes beyond an economic loss with which you are

Article Text

Copyright (c) Technical Analysis Inc.

3

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

comfortable. The RSI-price signal formation offers a unique opportunity to visualize an appropriate stop-loss level. From the daily trading ranges leading up to the signal, you can infer the approximate level below current price behavior where the evolving formation is either in the model or out of it. You know the per-tick value of the contract, so you can easily determine the dollar amount of loss you can comfortably tolerate. You can then adjust your trading parameters that represent your comfort zone in relation to the trading model, thus giving yourself a clearly defined optimum stop-loss point. PATTERN FAILURE As important as it is to be able to recognize those price-RSI patterns that succeed, you also want to be able to recognize when a pattern is not succeeding according to the tenets of our model. Understanding where things break down is as important as being able to see a potential trading signal, as this knowledge will allow you to make quick informed decisions at a time when a position may be evolving away from the model.

Complementary tools such as moving averages can confirm trading signals and help you stay in better touch with events. Pairing three - and five-day moving averages is my favorite supplementary tool. In Figure 6, a chart of April 1992 gold, you can see the divergence in price and the RSI between January 6 and February 25. On the buy side day of February 12, price has traded up within the downward price channel, creating a spike in the RSI. The shelf-like RSI pattern that can be seen between February 14 and February 20 makes an occasional appearance in charts when price is struggling to establish support. This pattern is also visible in Figure 1. On February 24, the closing price probes new low territory in relation to the low of January 6, and the RSI begins to accumulate support above its level of January 6. The next day, February 25, price closes marginally lower and support seems to be gathering beneath the R SI. Compare this RSI bottom formation to the one in Figure 3: The signal's pattern seems complete. The fact that prices closed at their lows on February 25 may have kept us from establishing a position on the close of this day. But the following day, February 26, prices climb slightly by the close, and the R SI appears to have reached support. The next day, prices gap up at the open and trade up for the day. By this time, more than a few traders would be aware of the technical trading opportunity at hand. An inside day with a very narrow price range follows (February 28). Could the faltering acceleration we see here be part of the pattern? Compare the second day in this price trend with the second day in our previous examples. During the next five days of trading, price moves into a shallow downtrend. We have clearly broken from the pattern we are studying and the position should be vacated. Complementary tools such as moving averages can confirm trading signals and help you stay in better touch with events. Pairing three- and five-day moving averages is my favorite supplementary tool. In our previous example, the moving averages would have warned you that staying with this buy-side trade was beginning to fight the near-term price trend. Such a situation is a reason to guard against becoming

Article Text

Copyright (c) Technical Analysis Inc.

4

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

emotionally invested in any single trade. In Figure 6, you would have entered the trade somewhere around $350.50 on either of the two days when the signal formed. Notice how many days during this downtrend during which we would have had to exit the trade without a significant loss. Once again, prices during the buy side day on March 11 have an impact on the RSI. The subsequent failure of prices to new lows the next day, March 12, continues the downward price trend and the uptrend in the RSI. On March 13, the RSI takes on a familiar look at the close and seems to be giving us a buy side trading signal (Figure 6). Should we try the trade again? The first time we tried it, the trend petered out but gave us a graceful way out; this time, the price and RSI patterns look more promising. Ideally, this trading signal should produce a strong acceleration in price trend as in Figure 1 or a trading range indicating accumulation in Figure 3. If you don't see price trending strongly, begin to look for hints of faltering price acceleration. The narrow inside day of February 28 is an example. If price seems to be hesitating, sell-side pressure may still prevail. If a pattern that was unsuccessful the first time it appeared repeats itself as in February 25 and March 13, it's a fair indication that prices are headed lower. But when you see such a multiple signal formation, stand back and view it in the context of a larger pattern. Doing so will help you gauge when price support is really being seen. In Figure 7, a chart of September 1982 lumber, we have another trading pattern failure. Our lowest close to date appears on June 28. Our price-RSI pattern appears June 21 through 24, including a failed recovery that makes for a broad RSI pattern, lasting this time for four days. On June 25, price closes at a new low as the RSI falls almost to its own support level. On June 28, price closes even lower, creating our now-familiar shallow, drifting R SI formation. This price trend lasted nine days, but price acceleration for the first four days, June 29 through July 2, wasn't strong enough to carry price above the near-term highs of 155. The one-day price consolidation on July 7 gave way to better momentum for the next several days, July 8 through 12. Prices struggled to hang on through July 16, then gave up without ever gathering enough momentum to clear out the block of shorts and stops up to the 155 level of May 26. Such an RSI signal formation should result in a strong reaction or the trader should become wary. BOTTOMS It's possible to read price bottoms, but it's not often and it's not easy. Many different bottom formations exist, and being familiar with them helps you discover where you are in the architecture of prices. Whereas we have studied relatively clear-cut examples here, patterns are unfortunately not always so easy to decipher. Studying historical price events will help you understand of price behavior and help you recognize the various patterns early in their development. Technical tools such as the price-R SI formation should be accumulated and used in conjunction with other techniques such as money management to create a sound trading environment for yourself. Even with that caveat, the RSI can help you determine how long to stay with a sell side position and when to reverse with a potential buy side price trend. It will also help you recognize whether the new trend is healthy with good acceleration. If you follow a trading index other than the RSI, the principles that we've studied here can still apply. Paying attention to daily volume and open interest will also help you read these trading signals. Using

Article Text

Copyright (c) Technical Analysis Inc.

5

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

other tools such as a pair of short-term moving averages or a second trading index meant to view prices from a different perspective might add to your confidence level. Some traders will need to study the calculations involved in the RSI to have confidence in it. New supply/demand events can happen any time and send new information into a market, but the technical structure of prices is reliable enough for the careful and disciplined trader to be amply rewarded. No two price events unfold in exactly the same way. By viewing historical charts containing different kinds of price and trading index behavior, you have a way to visualize the potential end of a price event. You will discover as well many variations on these patterns and be able to recognize them even when they become obscured by short-term price events. You can then be ready when that last moment of price action finally completes the picture. When other traders have been lulled to sleep by relatively quiet price action or their inability to sense the changing character of a trading environment, your intraday index will be an alert ally, quietly hinting at support or resistance and an opportunity for the vigilant. John Knaggs is a private trader.

ADDITIONAL READING Wilder, J. Welles, Jr. [1978]. New Concepts in Technical Trading Systems , Trend Research.

FIGURE 1: DECEMBER 1987 T-BONDS AND THE 14-PERIOD RSI. The basic RSI-price pattern for a bottom consists of a decline in price and an uptrend in the RSI. Look for an upward spike in the RSI, as on October 13, to alert you to a possible trend reversal.

Figures

Copyright (c) Technical Analysis Inc.

6

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

FIGURE 2: DECEMBER 1987 T-BONDS AND THE 14-PERIOD RSI. The RSI-price reversal pattern is a price decline with diverging RSI and the upward spike (May 18) on the RSI.

FIGURE 3: SEPTEMBER 1992 T-BONDS AND THE 14-PERIOD RSI. The reversal pattern correctly alerted you to the market bottom. The upward spike in the RSl occured on March 9. This time the market did not rally sharply but traded in a range, retested the lows and then advanced.

Figures

Copyright (c) Technical Analysis Inc.

7

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

FIGURE 4: JULY 1983 LUMBER AND THE 14-PERIOD RSI. This time the market traded in a flat range with the RSI trending slightly upward. The upward spike in the RSI occurred on March 23.

FIGURE 5: JULY 1986 LUMBER AND THE 14-PERIOD RSI. The RSI-price pattern does not produce the divergence between price and the RSI, but there is an upward spike in the RSI on February 3.

Figures

Copyright (c) Technical Analysis Inc.

8

Stocks & Commodities V. 11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

FIGURE 6: APRIL 1992 GOLD AND THE 14-PERIOD RSI. The RSI-price pattern produces a false signal in this example. An upward spike in the RSI occurred on February 12 and March 11.

FIGURE 7: SEPTEMBER 1982 LUMBER AND THE 14-PERIOD RSI. June 21 through June 24 produced the upward spike in the RSI. By mid-July the market faltered and a trader should consider abandoning the position.

Figures

Copyright (c) Technical Analysis Inc.

9