How Momentum Fits Into My Process

"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 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 timeframe you are observing. In other words, technical analysis works better the longer your time horizon. That whole, "Technical Analysis is just for short-term trading" is simply a lie.

As a definition, RSI is a momentum indicator that compares the magnitude of recent gains to recent losses in a range between 0-100. 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 down below. Now, instead of going into how J. Welles Wilder created the oscillator and how it works, I am going to focus on how I personally use it. Stockcharts.com does an incredible job of explaining it’s construction.

RSI has plenty of benefits to it’s users, but there are 2 primary ways that RSI helps my personal day-to-day charting. The first and easiest way is to identify what type of “Range” RSI is in currently. 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 $TSLA during 2012-2013. RSI remained in a Bullish Range:

On the flip side, markets in a "Bearish Range" reach oversold conditions during selloffs 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:

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.

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The 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 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 a vice versa. The same can be said for Divergences. You will see many more of them occur 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. See: Is Apple Stock About To Crash? (September 2012)

This is how I use RSI personally. I know a lot of market participants out there that 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.

I get a lot of questions from you guys asking me about RSI and momentum. I hope this helps to clear up any confusion and makes it easier to understand my point of view going forward!

Cheers and Happy Charting!

JC

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