BULLETIN #48

Valuable Tools for Traders - The RSI By Chuck LeBeau

In our past Bulletins we haven't written much about one of our favorite trading tools, the Relative Strength Index (RSI). As most of our members are aware, the RSI is a popular overbought -oversold oscillator. Stock traders must be careful not to confuse this indicator with the "relative strength" that is used to compare the strength of one stock with another or with an index. The RSI oscillator is another invention of J. Welles Wilder, the originator of ADX and many other valuable trading tools.

The RSI calculates the ratio of "up closes" to "down closes" over the period of time selected (usually 14 bars) and expresses the results as an oscillator with a scale of 0 to 100. Readings above 70 are commonly thought to indicate an overbought condition while readings below 30 are believed to indicate an oversold condition.

The RSI indicator is included in most charting software packages but the formula is very simple if you needed to calculate it by hand or in a spreadsheet.

RSI = 100 - (100/ 1 +RS) where RS equals the average of up closes of the last n (14?) bars divided by the average of down closes of the last n bars.

Here are two of our favorite applications of this valuable tool.

1. Defining dips in an uptrend. A "dip" occurs when the RSI declines by 10 (or more) points from a recent peak that was at a high level. For example, a drop from 80 to 70 or less would qualify as a dip as would a decline from 90 to 75. In our experience we have found that most RSI dips tend to be 25 points or more but in very strong trends (our favorite) the dips tend to be of a lesser magnitude. Our measurement of 10 OR MORE will work in either type of market. Once a "dip" has been defined we can either buy at the market or wait for some sign of a reversal. It is often a good idea to also consider and limit the minimum level that the RSI reaches on the "dip". If the RSI declines too far without reversing we have probably seen a market top, not a dip.

2. Defining rallies for profit taking. Once we have been in a trade long enough to accumulate a worthwhile profit it often makes sense to exit on strength rather than waiting to be stopped out on weakness. For example, once we have at least two ATRs of profit we want to be ready to exit whenever the RSI reaches 75 or more. (I prefer to use 75 and 25 as thresholds rather than the more popular 70 and 30 levels.) This strategy of exits on strength will tend to maximize our profits over the short run but may not be as effective as a trailing stop over the long run. However, if you are trying to trade effectively over short time frames it often makes sense to exit on strength rather than on weakness. This is particularly true for day traders who do not have the option of letting profits run indefinitely. Once the RSI reaches 75 or more we have the option of closing out the trade "at the market" or watching closely for the first sign of a change in direction. A lower close or a close lower than the open seem to work well for this purpose.

Other popular applications of the RSI can be found in our book (starting on page 124). As is true of most indicators, the RSI can be much more effective when its application is combined with a quick glance at the ADX. Typically the RSI indicates an oversold condition whenever it rises above 75 and many counter-trend traders look to sell short at this point. This procedure would be a very big mistake if the ADX were rising. When the ADX is rising, the RSI will tend to move more or less sideways at the high levels rather than reversing direction as it would normally be expected to do. Instead of breaking to the downside the market being tracked will remain overbought and will persistently continue to make new highs. Entering a counter-trend trade simply because the RSI indicates an overbought or oversold condition is a big error if the ADX is rising.

We would also caution our members about using the RSI level as a filter for entries. Many traders will not enter a new buy order if the RSI indicates an overbought condition. Most of the time this is an effective entry filter that avoids buying just before the market is ready to correct an abnormal price excursion. However, this procedure would be a very big mistake if the ADX were rising. When the ADX is rising, many of the best entry signals come when the RSI is at a high level. Our research indicates that eliminating these entries would reduce the profitability of the trading strategy substantially.

We believe that the RSI is a valuable trading tool that belongs in every trader's toolbox. Take the time to study it and become familiar with its many helpful applications.

Be sure to let us know if you come up with any exciting ideas on how to apply it.

Good luck and good trading.

* * * * * * * September Workshop -Limited spaces still available.

Learn How to Design, Test, Evaluate and Implement Profitable Trading Systems. Whatever your market and whatever your time frame you are certain to benefit from this carefully prepared two-day workshop. On September 15th and 16th Chuck LeBeau will personally teach a small group of traders the step by step process of how to design better trading systems.

It doesn't matter if you trade stocks or futures or if you are a day trader or a position trader. The procedures that need to be followed are the same and you will learn what you need to know to improve your systems at this informative Workshop.

Contact Chuck LeBeau at (310) 265- 9776 for more information or go to WWW.traderclub.com/workshop.htm

* * * * * * * * Visit our FORUM discussion group and share ideas with other traders.

The Traders Club Forum is the best discussion group for traders anywhere on the web. We have many lively and informative threads in progress that will increase your knowledge and generate helpful ideas. If you are new and need questions answered this is the place. You will find that our Club members are knowledgeable and very helpful. It's a very friendly and supportive group and you will be surprised at the amount of information and assistance that is available. The discussions are very high quality and best of all - IT'S ALL FREE.

Just go to http://www.traderclub.com/discus/board.html and take a look.

If you need more information send email to:

chuck@traderclub.com

Chuck Le Beau's System Traders Club http://www.traderclub.com
ph 310-265-9776
fax 310-265-9556