Relative Strength Index (RSI)

Developed in 1978 by J. Welles Wilder, the Relative Strength Index is one of the most popular and reliable indicators in the technicians arsenal. Often confused with "relative strength" (which is merely a ratio of the price of an issue divided by an index of the overall market), the RSI is an oscillator that measures the relative internal strength of an issues average upward price movement against its average downward price movement over a selected time frame (see Figure 2.7). It is computed on a scale of 0 to 100, with a value over 70 representing an overbought situation and a value under 30 representing an oversold situation. (Based on my experience, however, 70 and 30 should not be taken as absolutes, but rather as areas or zones near which an overbought/oversold condition might occur.)

Wilder also recommends looking for divergences between the oscillator and price action, as well as failure swings at or near the 70/30 overbought/oversold levels, and chart formations in the indicator itself, as additional signs of a potential price reversal. Although the RSI can be calculated over virtually any time span, Wilder recommends a 14-day period. The shorter the time span, the more sensitive (and volatile) the oscillator. The longer the time span, the slower and more stable the oscillator.

Moving Average Convergence-Divergence (MACD)

Another helpful piece of information for the technical analyst is the degree of an issues price/trend deviation. Price/trend deviation is determined by dividing the price itself by a moving average of the price. Since the moving average represents the trend

Figure 2.7 Relative strength index. An example of the RSI line.

of the issue, the resulting calculation reflects just how slow or fast price is rising or falling in relation to its trend.

A popular and useful indicator of trend deviation is called the Moving Average Convergence-Divergence Index. Developed by Gerald Appel in 1979, MACD is nothing more than an oscillator constructed from the difference between two exponential moving averages, one of shorter-term duration and the other of longer-term duration. While any time period may be used, Appel recommends a 12-period exponential moving average for the shorter term and a 26-period exponential moving average for the longer term. The indicator gets its name from the fact that the shorter-term moving average is constantly converging toward, or diverging from, the longer-term moving average.

The difference between the two moving averages, called the MACD or differential line, is plotted as an oscillator curve. A 9-period exponential moving average of the differential line, called the signal line, is then plotted beside the differential line. Buy signals are generated when the differential line is negative and then crosses from below to above the signal line. Conversely, sell signals are generated when the differential line is positive and then crosses from above to below the signal line (see Figure 2.8).

Because the indicator is constructed of moving averages, it serves to smooth out the data in highly volatile issues. (Note. At first glance, it may appear to novice technicians that the two lines on the MACD plot represent the short-term and longer-term exponential averages. Actually, the difference between the two moving averages

Figure 2.8 Moving average convergence-divergence. An example of the MACD line.

is a single curve [usually plotted as a solid line], and the other curve [usually plotted as a dashed line] is a 9-period exponential moving average of the first.)

Stochastics (STOC)

To complete the technical assessment of an issue, it is useful to know where the issue is currently trading relative to its price range over the past x number of periods. This is important because of the tendency for prices to close near the upper end of their trading range during an advance, and near the lower end of their trading range during a decline. Once the advance nears its end, prices begin closing farther and farther away from the high end of its trading range. During declines, the opposite is true. Prices tend to bottom out and then begin trading farther away from the low end of their trading range as the trend reverses direction. The stochastics oscillator, developed by George Lane, is a momentum oscillator designed to give the analyst a quantitative measurement of "position in range."

Although the term stochastic as used by Lane actually has no relation to the true definition of the word-"a naturally occurring random process"-its usage as applied in technical analysis refers to the term "stochastic equation." The indicator attempts to define the points in a rising or falling trend at which prices tend to cluster around the highs or lows for the period under consideration since this is the point at which trend reversals are signaled. The indicator consists of a family of oscillator curves, known as %K, Slow %D, and Fast %D, which are plotted and interpreted in a manner similar to the RSI.

The first curve, %K, represents the position of the close relative to the issues range over the preceding x number of periods and is therefore the most important. Fast %D is merely a smoothing, usually a 3-period simple moving average, of %K. Slow %D is typically a 3-period moving average of Fast %D, but all the curves can be changed to suit the issue and time frame under consideration.

According to Lane, oversold conditions exist below 20 and overbought conditions exist above 80. Buy signals are generated when both %K and Slow %D are below 20 and turn up, with %K breaking above %D. Sell signals are generated when both %K and Slow %D are above 80 and turn down, with %K breaking below Slow %D. Signals may also be generated by price divergence. The only variable parameters with stochastics are the number of periods in the trading range, and the number of periods used in the smoothing of Slow %D and Fast %D (see Figure 2.9).

Strength in Numbers

As mentioned before, indicator interpretation is an art form requiring a great deal of skill and experience on the part of the technician. While each of the preceding indicators is considered a "standard" in its own right, no one indicator should ever be depended on exclusively, for there is no Holy Grail in technical analysis. Rather, each