Saeed Ebrahimijam Spring 2013

DoğuAkdenizÜniversitesi Faculty of Business and Economics Department of Banking and Finance Fundamentals of Technical Analysis and Algorithmic Trading Chapter 16: Relative Strength Indicator (RSI) SaeedEbrahimijam Spring 2013 FINA417

Contents • Momentum oscillator concept (review) • RSI history • What is Relative Strength Index • How to calculate RSI • Overbought vs. Oversold • Failure swing in RSI • RSI Interpretation for trading • Polarized fractal efficiency Index(PFE) Fundamental of Technical Analysis and Algorithmic Trading

Momentum oscillator concept • Momentum is the rate of the rise or fall in price. Fundamental of Technical Analysis and Algorithmic Trading

Fundamental of Technical Analysis and Algorithmic Trading

History of RSI • The Relative Strength Index (RSI) is a price momentum indicator • By: Welles Wilder • published in a 1978 • book, New Concepts in Technical Trading Systems Fundamental of Technical Analysis and Algorithmic Trading

Introduction • Particularly those who are commodities and futures oriented. • The RSI is frequently confused with relative strength analysis, which compares the performance of two items (e.g., one stock with another or one stock with an overall market index). Don’t make mistake!!!! • It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period. Fundamental of Technical Analysis and Algorithmic Trading

CONCEPTUAL BASIS OF THE RELATIVE STRENGTH INDEX • RSI is a rate-of-change oscillator. • It measures the velocity at which prices are moving. • RSI was intentionally designed to address three flaws often associated with oscillators. • First, at times, oscillators move erratically because of the drop off of old data in their calculation. For example, if one has a 10-day oscillator and 10 days ago the price of the security moved up or down dramatically, the current oscillator reading will be a misleading low or high reading. • A second problem relates to the vertical scale for an oscillator. How high or low should the oscillator be so that it will signal buying or selling opportunities? • The third and final problem is the need to keep massive amounts of data for oscillator calculations. RSI presents a solution to these problems. Fundamental of Technical Analysis and Algorithmic Trading

HOW TO CALCULATE THE RELATIVE STRENGTH INDEX • RSI is calculated as follows: • The RSI ranges from 0% to 100 %. • The RSI is presented on a graph above or below the price chart. Fundamental of Technical Analysis and Algorithmic Trading

Let’s use 14 days as an example. • To get the average up value, add the total points gained on up days during the last 14 days and divide by 14. • The average down value is arrived at by adding the total points lost on down days during the last 14 days and dividing by 14. • Divide the average up value by the average down value to calculate the relative strength (RS). • Insert the RS value into the formula and calculate the first day’s RSI value. Fundamental of Technical Analysis and Algorithmic Trading

Updating RSI each period is easy. • Simply multiply the previous up and down average values by 13, add the latest day’s gain or loss to the up or down average, and multiply the total by 14. • Insert the new RS value into the RSI formula and recalculate the RSI. Fundamental of Technical Analysis and Algorithmic Trading

Number of periods • Wilder suggests the use of 14 days of data in the RSI calculation; however, other technicians have found that other time periods work with success as well. • The greater the number of periods used, the more stable the RSI is, and the fewer signals are generated. • Short-term RSIs tend to produce more signals than longer-term RSIs, including more false signals. Figure 15-1 compares RSIs of differing lengths—9 and 14 days—for the S&P 500 index. Note the difference in the number of crossings of the 70 and 30 lines. Fundamental of Technical Analysis and Algorithmic Trading

Shorter or longer timeframes are used for alternately shorter or longer outlooks. • More extreme high and low levels—80 and 20, or 90 and 10—occur less frequently but indicate stronger momentum. Fundamental of Technical Analysis and Algorithmic Trading

INTERPRETING THE RELATIVE STRENGTH INDEX • The RSI can be interpreted from the following five perspectives: 1. Extreme readings. 2. Chart patterns. 3. Failure swings. 4. Support and resistance. 5. Divergence. Fundamental of Technical Analysis and Algorithmic Trading

Extreme RSI readings • Extreme RSI readings signal the likelihood of major tops or bottoms. • Although the exact levels to use are subject to debate, Wilder recommends using levels of 70 and 30. - If the RSI rises above 70, a major top in market prices is likely. - A decline to below 30 suggests a high probability of a major bottom being made. Fundamental of Technical Analysis and Algorithmic Trading

Overbought and oversold conditions • An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. • Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued. - It’s generally better to buy a market when it’s oversold and sell when it’s overbought Fundamental of Technical Analysis and Algorithmic Trading

Chart patterns • The chart patterns presented in Lessons 3 through 5 are equally applicable to RSI as they are to regular price charts. • Often, chart patterns (such as a triangle or head-and shoulders top or bottom) can be seen in the RSI. • Since the same breakout rules apply to the RSI as to normal price charts, buy and sell points are frequently indicated. Fundamental of Technical Analysis and Algorithmic Trading

Failure swings • Failure swings can also be used in interpretation of the RSI. • what a failure swing is? - As illustrated in Figure 15-2, a top failure swing occurs when the index rises above 70, declines to a lower level (fail point), rises again but fails to reach the 70 level, and then falls below the prior lower level (a fail point). One would sell at that point. • Figure 15-3 illustrates a bottom failure swing. It is simply the opposite of a top failure swing. Fundamental of Technical Analysis and Algorithmic Trading

Failure swing in RSI • Even one step further is the failure swing, a term that Wilder uses to refer to "very strong indications of a market reversal." • Wilder uses failure swings to confirm his buy and sell points, and in the two figures below you can see that failure-swing points clearly do just that. Fundamental of Technical Analysis and Algorithmic Trading

Failure swing in RSI • Wilder thought that "failure swings" above 70 and below 30 on the RSI are strong indications of market reversals. • The center line for the relative strength index is 50, which is often seen as both the support and resistance line for the indicator: - If the relative strength index is below 50, it generally means that the stock's losses are greater than the gains. - When the relative strength index is above 50, it generally means that the gains are greater than the losses. Fundamental of Technical Analysis and Algorithmic Trading

Support and resistance • Support and resistance lines will often be apparent on the RSI before they are apparent on the bar chart of prices. • Breaking of support or resistance is interpreted in a similar fashion to the interpretation of price charts. Refer to chapter 7 on support and resistance for a refresher. Fundamental of Technical Analysis and Algorithmic Trading

Divergence • Divergence between prices on a bar chart and the RSI strongly suggests that prices will be reversing. • If prices are rising or flat and the RSI is decreasing, look for a turn downward in prices. • If, on the other hand, prices are declining or fl at and the RSI is increasing, expect prices to turn and move higher. Fundamental of Technical Analysis and Algorithmic Trading

RSI signal sample Fundamental of Technical Analysis and Algorithmic Trading

RSI signal interpretations for trading Fundamental of Technical Analysis and Algorithmic Trading

Polarized Fractal Efficiency Fundamental of Technical Analysis and Algorithmic Trading

Polarized Fractal Efficiency (PFE) • Hans Hannula presented his PFE indicator in 1994 issue of Technical Analysis of Stocks & Commodities magazine. http://www.traders.com/index.php/sac-magazine • This indicator is intended to portray the laws of "fractal geometry" in the form of an oscillator. • It is better to use it on price diagram. Fundamental of Technical Analysis and Algorithmic Trading

PFE calculation 1 • The formula is very complex. A description of this formula in words might be confusing. • The PFE is calculated of the Exponential Moving Average (EMA) of Effizent: Fundamental of Technical Analysis and Algorithmic Trading

PFE calculation 2 • The Polarized Fractal Efficiency indicator uses fractal geometry to determine how efficiently the price is moving. http://finmind.blogspot.com/2005/08/william-eckhardt-c-test.html Fundamental of Technical Analysis and Algorithmic Trading

Parameters • The adjustable period length can be chosen from 2 to 500. The most common settings will have a period length ranging from 8 to 30. • Use 14 days period of calculation. Fundamental of Technical Analysis and Algorithmic Trading

PFE Interpretation The more linear and efficient price movement, the shorter the distance the prices must travel between two points. The more "squiggly" the price movement, the less efficient it's travel. 1- The permissible values for PFE lie in the range between +100 and -100. Whilst a crossing of the zero line may be interpreted as a warning of an impending trend change, only values over +40 / +60 are usually regarded as a buy signal and those below -40 / -60 as a sell signal. 2- When the PFE is zigzagging around zero, then the price is congested and not trending. When the PFE is smooth and above/below zero, then the price is in an up/down trend. The higher/lower the PFE value, the stronger the trend is. http://www.amibroker.com/library/list.php Fundamental of Technical Analysis and Algorithmic Trading

PFE & trading decision making • The strength of the trend is measured by the position of the PFE relative to the zero line. As a general rule, the further the PFE value is away from zero, the stronger and more efficient the given trend is. A PFE value that fluctuates around the zero line could indicate that the supply and demand for the security are in balance and price may trade sideways. • Simple decision making of trading policy: Find maximum and minimum points on PFE diagram: - Max points are appropriate time for Sell. - Min points are appropriate time for Buy. Fundamental of Technical Analysis and Algorithmic Trading

PFE signal Fundamental of Technical Analysis and Algorithmic Trading

H.W . • Install a PFE indicator on your Metatrader software and find the PFE index on EURUSD price ratio. Then Interpret your findings. Fundamental of Technical Analysis and Algorithmic Trading

Saeed Ebrahimijam Spring 2013