Overbought/Oversold Indicators: The Relative Strength Index (RSI) and Stochastics

The overbought/oversold indicators are extremely useful indicators to structure good risky reward trades. However, I do not prefer using them alone as trading strategies. They should be used, like any other indicators, as tools to be combined with other indicators.

Relative Strength Index

The RSI is defined as the Relative Strength Index introduced by Welles Wilder in 1978. It is a cyclical indicator that tells us when prices are overbought or oversold. It is an effective tool to apply in a sideways market or choppy, slow, nontrending market. Avoid using it in long, violent trending markets as these markets stay overbought or oversold for long periods of time.

RSI= 100-(100/(1 + RS))

where RS equals the average of the closing values of the up days divided by the averages by the closing values of the down days.

A 14-day RSI works well with many stocks I trade. For example, in Figure 5.6, I used a 14-day RSI to trade Morgan Stanley. My strategy is simply to buy when RSI dips at or below the 25 level and short it when it rises above the 75 level. The two buy entries and two sell entries, as in Figure 5.5, are near perfect entries. However, my exits are based on support and resistance and not based on RSI. RSI is only my entry tool.

Morgan Stanley is a good stock to apply RSI because of its sideways volatile nature with big price ranges. That nature is due to its underlying fiindamenrals. So you have to do some fundamentat research and historical chart analysis to pick the proper stock or market to use the RSI. Never apply any technical indicator to a market or stock blindly. Homework is the key.

Traders have used the RSI in many unaccountable ways. But the basic idea is to buy a market when it is oversold and sell the market when it is overbought. Some traders like to buy when the RSI starts dipping below the 25 RSI line, and some only buy when it moved below that line and just recently crossed back above the 25 line. On the sell side, some traders like to sell when the RSI starts crossing above the 75 RSI line, and some only sell when it has moved above that line and just recently crossed back below the 75 line.

There are many other ways to play the RSI but the basic idea is never to buy an overbought market and never sell into an oversold market. Always buy an oversold situation and sell into an overbought market.

Figure 5.6 Price chart showing buy and sell points as determined by the rsi index.

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Stochastics

The stochastics indicator was invented by George Lane. Like the RSI indicator, it is a cyclical overbought/oversold indicator and is used similarly. Unlike the RSI, it involves two components instead of one. The formula for the first oscillator, %K, is as follows:

%K=100 ((C-L)/(H-L))

where is todays close, H is the highest high for the last n days, and L is the lowest low for the last n days. The formula for the second oscillator, %D, is as follows:

%D= 100 (H3/L3)

where H3 is the three-period sum of - L in the %K equation and L3 is the three-period sum of H - L.

The more sensitive of Lanes two oscillators (with more spikes) is %K, but it is %D that carries more weight and gives the major signals; %D is approximately the three-period average smoothing of %K and, therefore, less sensitive.

There are numerous ways traders in the 1990s have used the stochastics depending on the market being traded. Figure 5.7 shows the daily chart for Japanese yen spot and stochastics. As with the RSI, I like to buy when both %K and %D are below the 25 line and go long immediately when the more sensitive %K crosses over the %D line. And I would go short when both were above the 75 line and when %K dips below the %D. One can use the stochastics as an exit tool as well, but I prefer to exit my trades based on chart patterns like support and resistance.

The approaches and market for applying the stochastics should be the same as the RSI since they are both overbought/oversold indicators. Many other momentum indicators resemble the RSI and stochastics, but the main idea is the same, which is selling overbought levels and buying oversold levels in choppy nontrending markets with price big ranges. Once again, I do not agree the use of mechanical entry on any one of these indicators alone. These indicators, however, could be combined with the traditional chart indicators such as trendlines and support/resistance to improve the odds of the entry.

Putting Everything in Action

An example will illustrate how to put these popular indicators and technical tools together for successful trading.

Referring back to the Eli Lilly chart (Figure 5.4), we have a breakout at circle "A" of a small round cup resistance pattern with good volume. The breakout point will be a good buy entry point. You should give yourself a tight stop (e.g., a 1.5 point stop) when playing breakouts since a lot of breakouts are false. I personally avoid