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Mastery Series Mastering Market Momentum and RSI

Mastering Market Momentum and RSI

This Lesson:• Introduction to Momentum

• Rate of Change

• Analyzing Momentum Indicators

• Relative Strength Indicator (RSI)

• Applying the RSI to Your Analysis

Introduction to Momentum IndicatorsMomentum Indicators

• Analyzing the movement of price identifies changes in direction after it takes place.

• Traders have often used momentum to try and identify these changes in direction before they occur.

• Momentum indicators are not a crystal ball and must be considered in context withprice analysis.

• Momentum will often begin diminishing before a reversal in price.

• There may be times when price and momentum change simultaneously.

• Think of momentum indicators like a volleyball game…

• One way we might determine when the volleyball was getting ready to change directions (naturally) would be to measure how much height it was gaining compared to some point in time previously.

• We could then chart the changes and label it the “Rate of Change” indicator.

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Mastery Series Mastering Market Momentum and RSI

Rate of ChangeRate of Change

• The Rate of Change indicator is one of the simplest ways of measuring momentum.

• It is constructed by dividing the current price by a historic price.

• To make reading the indicator more intuitive, charting applications often use 0 as the reference point for the data instead of 1.00 (100%).

• Example 1:

➡ Stock ABC is currently trading at $100

➡ 10 days ago ABC was at $95

➡ The current ROC is: 100 ÷ 95 = 1.0526 (105.26%)

➡ Alternately we could say the ROC is 5.26

• Example 2:

➡ Stock XYZ is currently trading at $100

➡ 10 Days ago YXZ was at $105

➡ ROC is: 100 ÷ 105 = 0.9523 or simply -4.76

Date Closing Closing 10 Days Prior

Rate of Change

7/14/15 117.85 112.40 4.85

7/15/15 118.30 113.48 4.25

7/16/15 119.07 115.13 3.42

7/17/15 118.86 114.97 3.38

7/20/15 119.58 115.70 3.35

7/21/15 119.31 117.10 1.89

7/22/15 119.33 115.19 3.59

7/23/15 118.80 115.60 2.77

7/24/15 118.91 116.44 2.12

7/27/15 118.25 118.05 0.17

7/28/15 118.46 117.85 0.52

7/29/15 119.84 118.30 1.30

7/30/15 120.03 119.07 0.81

7/31/15 120.00 118.86 0.96

8/3/15 121.12 119.58 1.29

8/4/15 121.69 119.31 1.99

0

1

2

3

4

5

117

118

119

120

121

122

7/14

/15

7/16

/15

7/20

/15

7/22

/15

7/24

/15

7/28

/15

7/30

/15

8/3/

15

Closing Rate of Change

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Mastery Series Mastering Market Momentum and RSI

0

2

4

117

119

121

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Mastery Series Mastering Market Momentum and RSI

Analyzing Momentum IndicatorsAnalyzing Momentum Indicators

• There are three primary ways to analyze a momentum indicator:

➡ Overbought / Oversold Lines

➡ Trend Reversals

➡ Divergence

• Momentum analysis should serve as “supporting evidence” for an opportunity identified through price analysis.

Overbought / Oversold Lines

• Overbought & Oversold lines provide a context within which we expect the momentum to remain.

• Breaching these lines suggests the given momentum is unsustainable.

• Beware that strong trending markets can remain at or beyond overbought / oversold lines.

• During a trending market, consider a breach of the the counter-trend line to be a better entry signal

• Said differently, a bullish market will be less sensitive to an overbought momentum indication and vice versa.

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Mastery Series Mastering Market Momentum and RSI

• Consider a re-crossover as a preferred entry signal.

• Example: an oversold stock in a bullish market might be a good bullish trade candidate when the ROC indicator crosses up through the oversold line.

Trend Reversals

• Support & resistance and trend-lines can also be used in momentum analysis.

• Similar to the price graph, a breach of a line can represent a change in direction of momentum.

• Use the same rules for drawing lines on a price graph.

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Mastery Series Mastering Market Momentum and RSI

Divergence

• Divergence is one of my favorite ways to analyze a momentum indicator.

• It occurs when momentum peaks are inverse to peaks on the price chart.

• Typically the price graph will resolve in the direction of the momentum indicator.

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Mastery Series Mastering Market Momentum and RSI

Smoothing Momentum

• There are two primary problems with raw momentum measurements:

➡ Large historical movements can have a big impact on current readings, creatingmany false signals.

➡ Momentum ranges vary dramatically from chart to chart.

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Mastery Series Mastering Market Momentum and RSI

Wouldn’t it be excellent if we had a smoothed momentum oscillator with a universal range?

Relative Strength Indicator (RSI)Relative Strength Indicator

• Developed by Wells Wilder

• A momentum oscillator that measures the strength of a chart against itself

• RSI = 100 -

• RS is the Average Gain ÷ Average Loss of (n) previous sessions

• Solves the two problems:

➡ Smooths erratic movements

➡ Constant range for comparisons (0 - 100)

1001 + RS

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Mastery Series Mastering Market Momentum and RSI

RSI Settings

• Jeremy likes a 7-period setting.

• I like a 10-period setting.

• Wilder himself liked a 14-period setting.

• You like _______ ?

Overbought Standard is 70

Oversold Standard is 30

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Mastery Series Mastering Market Momentum and RSI

RSI Settings

• The fewer days factored in the indicator, the easier it is to see Overbought andOversold scenarios.

• Unfortunately, the larger fluctuations create more false signals.

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Mastery Series Mastering Market Momentum and RSI

Applying the RSI to Your AnalysisReading the RSI

• We will use the same three analysis techniques discussed earlier.

➡ Overbought / Oversold readings

➡ Line & trend analysis

➡ Divergence

Rules of Thumb

• Counter trend overbought or oversold signals may be good opportunities to enter a trade with the trend.

• Overbought or oversold in the direction of the trend might be a good point to take profit.

• You want momentum to be trending with the overall price trend.

• Divergence is a good time to do nothing.

• To further strengthen your momentum analysis, look for opportunities where longer-term charts (weekly) show similar momentum indications to your daily charts.

Oversold Oversold

Overbought Trend Line Divergence

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Mastery Series Mastering Market Momentum and RSI

Oversold

Overbought Trend Line

Overbought

Trend Line

Divergence

Divergence

Divergence

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Mastery Series Mastering Market Momentum and RSI

Next Steps• Get the indicator loaded into your charting application.

• Back Test / Back Trade this new type of analysis to get very comfortable with it.

• Try these exercises for 2 years of history:

➡ Notate how price responded to overbought and oversold signals by ROC.

➡ Notate how price responded to a break of the line analysis on ROC.

➡ Notate how price responded to divergence signals on ROC.

➡ Experiment with different time settings on RSI.

➡ Notate how price responded to overbought and oversold signals by RSI.

➡ Notate how price responded to a break of the line analysis on RSI.

➡ Notate how price responded to divergence signals on ROC. Experiment with RSI on daily and weekly charts.

• Once you have a good idea of how the indicators are functioning, take the time to update your personal trading plan.

Divergence