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RSI


Whirlpool and the Relative Strength Index

08/24/00 09:36:20 AM
by David Penn

Three successively higher peaks don't mean a thing when the relative strength index has a failure swing . . . Here is a tale of two trends.

Security:   WHR
Position:   N/A

The relative strength index (RSI) should not be confused with the general term "relative strength". Relative strength refers to the performance of a stock or commodity when compared to the overall performance of the market in which that particular stock or commodity trades--for example, the relative strength of Yahoo! vis-a-vis the Nasdaq Composite Index. The RSI, by contrast, refers to the indicator developed by Welles Wilder to help refine methods for determining overbought and oversold conditions. Since the indicator's introduction in the late 1970s, RSI has enjoyed great popularity among traders as a valuable approach to studying and profiting from market trends.

On the RSI, overbought conditions are signaled when a reading of 70 or more is determined on a scale from 0 to 100. Oversold conditions are signaled at a reading of 30 or less. The philosophy behind overbought and oversold conditions is that they represent major opportunities for reversals. The suggestion is that selling an overbought stock will enhance the likelihood of selling on a high. Conversely, buying an oversold stock will increase the chances of acquiring that stock at a discount. Mathematically speaking, the RSI refers to the relationship between the current price and its performance over a certain number of periods (RSI developer Wells Wilder choose 14 days as a default). The average of price rises, from close to close, over a set period and the average of price declines, from close to close, over a set period are presented as a ratio. The ratio is increased by one and the result divided into 100. The relative strength index is 100 minus this last figure.

Graphic provided by: Tradecast Securities, Inc..
 
One of the helpful aspects of the RSI is the way the indicator itself can be charted and used to anticipate price action. Often, the RSI will form patterns or otherwise alert to a reversal condition some time before the price confirms that a reversal is imminent. The example below of Whirlpool (NYSE: WHR) will show how the RSI can do this.

Looking solely at the price action of Whirlpool beginning in April 1999, we can see WHR developing three successively higher peaks. The first peak develops very early in May 1999 at 73, the second peak occurs in late July 1999 at 76, and the third peak occurs in late August 1999 at a slightly higher 77. While the uptrend appears to be slowing a bit, it is still positive and, ordinarily, the three successively higher peaks would be cause to believe that a significant bull trend might continue. However, while the chart of the price action of WHR between May and August 1999 says "bull", the action of the RSI charts a different, if not totally opposite, course. The RSI also shows a peak in early May 1999. But where WHR goes on to a higher peak two and a half months later, the RSI moves to a lower peak and when WHR follows up a month later with another new high, the RSI moves to a peak even lower than the previous one. As the chart shows, the more WHR seems to want to go up, the more its RSI wants to go down. As you might imagine, the RSI wins this battle. By September 1999, WHR has dropped from 78 to a low of 60. There is a brief rally in October, but after that, WHR declines to 50 by the beginning of March 2000. There is another rally in May, but by August 2000, WHR is closing in the low 40s.

What happened? The RSI effectively forecast WHR's downturn by registering three successively lower peaks while the price was achieving three successively higher peaks. Ordinarily, when this occurs, the RSI is said to be diverging and, while this is a powerful signal, it does not mean that a sell is automatic. However, when we take into account the fact that the RSI has moved into overbought territory with the first peak, yet failed to follow the price up into higher territory, the resulting action makes the sell signal all the more compelling. When prices in an uptrend reach new highs and the RSI registers overbought, but does not itself reach new highs, then this divergence is called a failure swing. Similarly, when prices in a downtrend reach new lows and the RSI registers oversold, but does not follow with new lows of its own, then a failure swing has occurred and a reversal is imminent.

The failure of the RSI to match the third successively higher peak in price would have served as valid enough warning that WHR was headed downward. However, there are a few caveats that should accompany any trader's use of the RSI as a buy/sell indicator. Foremost, markets that are trending respond best to the RSI and its overbought/oversold signals. Markets that are in persistent trends, upward or downward, need to be approached more warily when deploying the RSI. Trending markets tend to permit overbought situations to develop and endure for longer periods of time than in non-trending markets. The same, conversely, can be said for downtrends, in which oversold situations can proliferate and remain in effect. Additionally, the scale of 70 and above for overbought conditions and 30 or below for oversold conditions can be shifted in trending markets. In these situations, overbought readings may be reached at 80 or 90 in a bull market and oversold readings may not develop until the RSI drops to as low as 20 or 10 in bear markets. As powerful as the RSI is, when used with trending markets, it is best to take the relative strength index . . . relatively.



David Penn

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

Title: Technical Writer
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