Momentum is a word that is used an awful lot when referring to public markets. You hear people talk about “momentum stocks” or how they’re seeing a “momentum shift”. Unfortunately most of these references are just off-the-cuff sort of statements that don’t have any real meaning. “It sounds good, so let’s use it”, kind of mentality. For me, it is a really important part of my process and I want to explain to you how I use it.
First of all, I am not an oscillator junkie. We all know that guy with 27 indicators plotted on his chart. That isn’t me. This is the sort of thing we want to avoid:
Relative Strength Index
I like my charts clean. It’s amazing how much you can see when you just get everything else the hell out of the way. My preference is a 14-period Relative Strength Index, otherwise known as RSI. Don’t confuse this with “Relative Strength”, which is one security relative to another, often times the S&P500. When we refer to the “Relative Strength Index”, or “RSI”, we are describing a momentum indicator.
Also, when I say “Period”, I am referring to all timeframes. So if I am analyzing a daily chart, we are using a 14-Day RSI. If we are looking at the weekly chart, we are using a 14-Week RSI. Markets are fractal, meaning that supply and demand behaves the same way regardless of your time frame. In fact, contrary to popular belief, supply and demand dynamics get more reliable the larger the time frame you are observing.
As a definition, RSI is a momentum indicator that compares the magnitude of recent gains to recent losses in a range between 0-100. This 100 points range means that RSI is an “Oscillator”. So RSI is a Momentum Oscillator. Traditionally, a reading above 70 is considered to be overbought, while a reading below 30 is considered to be oversold. I say, traditionally, because you will see how we prefer to use it in a minute.
Buy Side Institutions look for 2 things: Momentum and Relative Strength. We want to put ourselves in the shoes of a Fund Manager looking to allocate Billions of Dollars in assets on Monday morning. He can’t sit there waiting for something to move. There is too much opportunity cost involved. We want to approach the marketplace with that same mentality.
Bullish & Bearish Ranges
Momentum analysis has plenty of benefits to its users, but there are 2 primary ways that RSI specifically helps my personal day-to-day charting. The first and easiest way is to identify what type of “Range” RSI is in currently. The second is to use momentum as a confirmation that the primary trend is still in place or if there is a divergence warning us of a change in trend.
When the oscillator is in a Bullish Range you will often see it reaching overbought levels during rallies and finding support near 35-40 during corrections. Although we are told that 30 is oversold, the key area to watch for is 35-40 to make sure that the indicator is still in a “Bullish Range”. Also note, the strongest markets tend to stay above 50.
Here is a good example of Gold prices during 2009-2011. RSI remained in a Bullish Range the entire time. It wasn’t until momentum started getting oversold in late 2011 that it was clear something was wrong. And as it turns out, gold prices immediately fell another 30%. So momentum was not only an indicator of strength throughout 2009-2011 but also as a sign of weakness over the next several years.
This is a chart of Tesla during 2012 as it set up for its explosive 400% move higher. Notice how during this entire consolidation in 2012 momentum never hit oversold conditions. Then as it started to get overbought confirming the new uptrend, you got the breakout:
On the flip side, markets in a “Bearish Range” reach oversold conditions during sell-offs and fail to hit overbought conditions during counter-trend rallies. The oscillator tends to go no higher than 60-65 during counter-trend rallies and the worst markets stay below 50.
Here is a good example of JP Morgan $JPM during 2008 when prices were falling and momentum was in a Bearish Range:
Here is a ratio chart of emerging markets vs the S&P500. When looking at price, this is obviously in a clear downtrend defined by lower lows and lower highs. Look at momentum staying out of overbought conditions but consistently getting oversold on selloffs.
These Ranges are probably the easiest and most common sense ways that I like to use the Relative Strength Index. If I want to buy a stock that keeps hitting oversold conditions during corrections, I have be aware of the fact that this is probably just a counter-trend rally that I would be buying. In addition, once a stock hits overbought conditions and enters into a new Bullish Range, I can see that something is probably changing.
Nothing is perfect and neither is this. Sometimes you will see markets hitting oversold conditions on a sell-off and then it reaches overbought conditions on the ensuing rally. These mixed signals generally signal a lack of trend. Identifying lack of trends is helpful too and saves us some headaches.
Divergences and Confirmations
This first way we use RSI is really to help put things into context from an analytical perspective. The second way is more for execution purposes. We want to look for Divergences in Momentum. There are “Bullish Divergences” and there are “Bearish Divergences”. They signal, at the very least, a change in trend, and often a reversal in trend.
A Bullish Divergence is when prices in a downtrend make a lower low while momentum puts in a higher low. The first low in RSI, the lower low, if you will, must hit oversold conditions. The second low in RSI, the higher low in the bullish divergence, does not have to hit oversold conditions. In fact, it’s a more powerful signal when the first low hits oversold conditions and the second low does not.
Here is a good example of Silver in 2012 putting in a Bullish Divergence. Notice how at first, it just signaled a change in trend, from down to sideways, and ultimately it reversed higher:
The Bearish Divergence works the exact same way. First, we need a prior uptrend, then we need to see a higher high in price and a lower high in RSI.
Here is a good example of the U.S. Dollar Index early in 2009 putting in a higher high in price while momentum put in a lower high. Down we went after that:
The idea here is to use them in conjunction with other technical tools. In this case, we’re looking at a bearish momentum divergence near former resistance levels. We can take it one step further and use our correlation analysis to see that at the time, the US Dollar Index and S&P500 had a very high negative correlation. Catching this US Dollar bearish divergence would have signaled to buy US Stocks, and specifically the S&P500, in this case:
Divergences On Multiple Timeframes
The larger your timeframe, the fewer changes you will see in RSI. In other words, if a market is in a Bullish Range on a weekly timeframe, it is likely to stay in one for a while. As opposed to a Daily chart, where you will see more frequent changes from a Bullish Range to a Bearish range and vice versa. The same can be said for Divergences. You will see them more frequently on short-term timeframes than on larger ones.
The best scenarios are when the weekly timeframes and daily timeframes both match up. If the weekly and daily RSI readings are bullish, that’s better than if they disagree, and same with bearish readings. Even more importantly, when you have the same divergence on both daily and weekly timeframes, those can be the most powerful moves.
Apple in 2012 is a great example of both timeframes coming together:
I was very vocal about these divergences in Apple at the time. And it wasn’t hard to spot, they all happened at the same time. First, here is the weekly chart of Apple putting in new highs in the second half of 2012, and momentum diverged negatively on those highs. Then when prices broke the uptrend line to confirm, there was no reason to be involved from the long side. Also, notice how momentum started to hit oversold conditions to confirm the bearish trend in place.
We saw the same thing on the daily timeframe. Look at the new highs in price and lower highs in momentum. This was a clear sign of weakness coming when both the daily timeframe and weekly confirmed one another.
Divergences In Relative Strength
To take things one step further, here is Apple relative to the S&P500, which represents the relative strength of Apple in 2012. The relative strength chart also made a new high in late Summer only to put in a bearish divergence, just like what was taking place in the absolute price charts of AAPL.
These relative strength principles can be applied across timeframes and intermarket ratios. Momentum analysis is based on price. Those price changes can be analyzed using the same momentum principles we apply to say, the price of a stock.
This is how I use RSI personally. I know a lot of market participants out there who like using this oscillator in many different ways, looking for positive and negative reversals, changing the periods from 14 to 13 or 19, adding a smoothing mechanism to RSI to find moving average crossovers, etc, etc. There is no right or wrong way to do this. Also, there are many other momentum indicators like MACD, ROC or Stochastics. I know a lot of really smart people who use them. I don’t.
Also, momentum is just a supplement to price action, whether using RSI or any other indicator. Price is the only thing that pays and is by far the most important indicator of all. Everything else is just to supplement the analysis of price. It can be easy to forget that.
If you are interested in learning more about RSI, I recommend Connie Brown’s Technical Analysis For The Trading Professional. RSI is something that I incorporate into my work every day. This book helps you to think outside the box and explains how to manipulate different oscillators so you get signals that others wouldn’t because they use default settings. This one really gets your mind going in ways that other books simply do not. To me, that adds a ton of value.
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