Utilities, Divergences, And The StochRSI

07/03/07 08:56:46 AM

by David Penn

What does Tushar Chande and Stanley Kroll's marriage of the stochastic and the relative strength index tell us about the potential for a bottom in utilities stocks?

Security: $UTIL
Position: N/A

What does Tushar Chande and Stanley Kroll's marriage of the stochastic and the relative strength index tell us about the potential for a bottom in utilities stocks? Of the two, I've always been partial to the stochastic than the relative strength index (RSI). I'm not sure how this came about; maybe it was simply that the stochastic was the first oscillator I came across and I just decided to stick with it. Maybe, as Uma Thurman's character suggests in the retro-thriller movie Pulp Fiction about "Beatles people" and "Elvis people," there are "stochastic people" and "RSI people" — and I just happen to fall in the former camp.

Fortunately, much of what I like about the stochastic — the BOSO methodology, the "ANTI"-based hooks — can be replicated if not in the RSI itself, then with a variation on the RSI called stochRSI, created by Chande and Kroll and discussed in their book The New Technical Trader.

Essentially, all the stochRSI does is take the RSI and use it as the inputs in the equation for the stochastic oscillator. So instead of measuring where market closing prices are in a given range over a given period of time, the stochRSI measures where the RSI values are in a given range over a given period. StochRSI is very much what it sounds like: a stochastic of the RSI.

Treating the RSI this way means that we can use it for more than spotting divergences; we can also enter or reenter overbought or oversold markets that momentum oscillators like the RSI and the stochastic have, when used traditionally, encouraged us to avoid.

Let's take a look at both applications of the stochRSI using the recent price action in the Dow Jones Utilities Average (Figure 1).

FIGURE 1: DOW JONES UTILITIES AVERAGE, DAILY. Divergences in the stochRSI anticipated both the top in utilities stocks in late May as well as what appears to be a bottom in utilities stocks in late June. If in July the stochRSI remains in the overbought area above 0.80, then traders can expect continued advances for the stocks of this group.

Graphic provided by: Prophet Financial, Inc.

While many markets spent the early summer of 2007 in sideways corrections, the correction in the Dow Jones Utilities Average (DJUA) was much more severe. Topping out around the 535 mark in late May, the DJUA fell to as low as 485 in a month's time. That top in the DJUA was anticipated by a negative divergence in the stochRSI. Note how the oscillator made a pair of lower highs in late April and May, compared to the higher highs in price.

Another type of divergence appears to be in the making over the course of June, as a pair of lower lows in price matches a pair of higher lows in the stochRSI. This kind of positive divergence is very often found at market bottoms and can be a strong indication that a move downward has run its course.

The bullishness of the recent positive divergence appears to be underscored by the rally that has developed in the wake of the lower low in late June. Note also how the stochRSI is surging into the overbought territory. While this might be seen as a potential drawback to the move higher, it is worth considering that given the positive divergence in the stochRSI, the path of least resistance remains upward until the market provides evidence that the move higher should be suspect.

As was the case with the stochastic using the BOSO methodology and as can be seen in March and April in Figure 1, markets that become overbought and stay overbought are, generally speaking, markets worth buying. And should the DJUA's recent leap into overbought territory be only the first step in a lasting occupation of that terrain, traders will be able to credit the divergences and overbought extremes of the stochRSI for getting them in the trade and, as long as it is profitable, keeping them there.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Utilities, Divergences, And The StochRSI

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