Trading the Afternoon Market

RSI & Stochastics

I have divided this video into two sections. Video 4A is basically the text portion shown below the videos. But some people prefer to watch instead of read, so that is available here. Video 4B looks at several charts to illustrate the text.

There is a toggle switch in the bottom right corner of the video player if you'd like to enlarge the screen for easier viewing.


Video 4A






Video 4B:






In our second video, we looked at Support and Resistance lines. And we noticed that these lines often represent turning points, or pivot points, for the stocks we're following. So, as price approaches the mid-line of the Bollinger Bands from the underbelly of that line, we know that it takes a lot of strength for the stock to move past that line. We also discovered that a line of resistance can become a line of support. We saw that in the last video when we looked at Contextual Trading and we studied how the Dow has responded to the 8100 line in the first half of 2009.

So, how do we determine if a stock is going to go past a line or retreat from it? Knowing the line is there is one thing. Predicting what price will do when it hits it is another thing.

As we move through this video series, we'll be adding layers of indicators to try and help us solve this problem. Using a combination of indicators gives us more confidence in our decisions. Rightly interpreted, these indicators can raise our success rate in trading to new highs. These indicators become part of our Contextual Trading theory and help us in making wise decisions.

The two indicators that we'll look at today are RSI (Relative Strength Index) and Stochastics. Used in conjunction with Support and Resistance lines, these two indicators will add clarity and confidence to our trading. So let's get started.

RSI

Depending on the chart service you are using, your charts may have RSI labeled differently. It is sometimes called Wilder's RSI, after the guy who created the formula. Some will call it simply Relative Strength or something else. But RSI is just what it claims to be. It measures the strength of the stock. Some charting services will allow you to determine the "relative" part of the formula. For example, do you want to measure "relative to the Dow Jones 30" or "relative to another stock within the same sector". Your charting service may not allow you to specify this part of the equation and that's okay. The default settings from your broker will work just fine.

Most charting services will allow you to specify the period setting for the RSI. You can test various periods and see what works best for you. But, for the purpose of day trading, I typically use a very tight setting of 4 or 5. The lower the number, the more whipsaws you'll experience. But, it also lets you know more quickly when a change is likely to occur.

In my trading, I have found that drawing three lines on the RSI portion of my chart is helpful. The three lines should be drawn at 30, 50, 70 if possible. You will see these lines drawn on the charts in the videos. And here are the general interpretations for those three lines.

* If a stock has been falling in price, and RSI has fallen below the 30% line, then a rise above that line is considered bullish, or strong.

* If a stock has been falling in price, and RSI turns at the 50% line in order to go back up, then this is considered bullish.

* If RSI falls below 70%, then this can mean that price will soon dip. If it continues to break through the 50% line, then it is certain that price will continue to fall.

* RSI can stay above the 70% line or below the 30% line for extended periods of time. And price can continue to climb or fall, respectively, with little change in the RSI percentages once they are these two extremes. But, it is the movement between these two lines that generally represents the best opportunity for profit because price will follow this movement.

I will show examples of these settings in action once we get to the videos.

Stochastics

The simple definition of Stochastics is that it reveals overbought and oversold situations to the trader. So, in simple terms, when Stochastics are near the top of their window, then the stock is said to be overbought. If it is overbought, then buyers will stop bidding the price higher and the asking price is likely to be compromised. When this occurs, of course, price begins to fall. I won't go into the mathmatical forumla behind this indicator, but it would be accurate to say that it reflects if a stock is moving in or out of its price comfort zone.

Likewise, when the Stochastics indicator is near the bottom of the chart, then the stock is said to be oversold, which represents a buying opportunity for someone who has been waiting for a better price. Some charting services will allow you to control the settings for Stochastics. For day trading, I use 5 for the %K line and 3 for the %D line. But, you can use your system's default settings or play with these numbers to see what works best for you.

On the charts used in this video series, you will see RSI and Stochastics plotted together. I do this simply because it saves space. But I also plot them together because the signal is clearest when these two indicators act in unison. So let me explain that.

When I see Stochastics rising to 80% while RSI is still at 40%, then what could happen next? The stock could become overbought before solid strength is allowed to build. Instead, I strongly prefer that these two indicators move in unison, moving together from the bottom of the chart and rising up and through the 30% line. I also like to see the angle both indicators to point as steeply up as possible and I want them to do this together. If the Stochastics indicator is pointing sharply up at a 75% angle, and RSI is pointing only at a 45% angle, then it doesn't mean the stock will not rise in price. But, if I had to choose between two stocks, then I would choose the one where the indicators are moving together, with the sharper angle the better.

So now you have two more indicators to add to your charts. As we add layer upon layer to your charts, wthout doing them all at once, you will gain more clarity regarding how they function and you will learn what weight to give the various indicators in your own trading.