Mastering the Basics of Momentum Indicators

RSI – Relative Strength Index

The Relative Strength Index (RSI) is one of the simplest ways to gauge momentum. Developed by J. Welles Wilder in the 1970’s, it’s based on the simple notion that prices will tend to close higher in an uptrend and close lower in a downtrend.

RSI is constructed by comparing the average gains on up days and average losses on down days over a given period, usually 14 days. A shorter time period may be appropriate for less volatile markets. The reading is a number between 0 and 100. Rising markets will produce readings closer to 100 while falling markets will result in readings closer to zero.

Overbought/Oversold

The RSI is very useful for determining whether a market is overextended. Markets are said to be overbought if the RSI rises above 70 and oversold if it falls below 30. This can be modified to 80/20 for a market that is a strong trend. In a rising market, the RSI tends to look overbought at times.

Failure Swings

Divergence is the most important characteristic of the RSI. By divergence, we mean the indicator moving in an opposite direction (diverging) from the security. For instance, if the RSI starts to fall but the security keeps setting new reaction highs, it can foreshadow a reversal. But the RSI indicator provides a more precise version of divergence known as ‘failure swings’ which offer a confirmation of the trend change signaled by divergence.

Bearish Failure Swing

For a bearish failure, or failure swing top, the RSI enters overbought territory – above 70 – and then makes a lower high, which may or may not be below 70. The security continues to rise and makes a higher high. This creates a bearish divergence with a trading signal coming when the RSI lower reaction low.

An example of a bearish failure swing predicting a reversal.

Bullish Failure Swing

For a bullish failure swing, also known as a failure swing bottom, the RSI enters oversold territory – below 30 – and then makes a higher low, often but not always above the 30 level. At the same time, the security continues to fall and makes a lower low. This situation would be termed simple bullish divergence. The signal comes when the RSI forms a new higher reaction high.

An example of EURUSD bullish failure swings predicting a strong rally.

Stochastics 

Stochastics is a momentum indicator that shows where the most recent closing price fits in relation to the price range over a predetermined number of days, usually 14. The indicator is based on the premise that prices have a tendency to close at or near highs in when the security is in an upward trend, and at or near lows when prices are trending lower.

A reversal signal is given on divergence. For example, if the market continues to make new highs but prices are tending to settle at the lows of the day, it can foreshadow a reversal in the uptrend. From a logical viewpoint, this makes sense as if prices are not able to settle at the highs of the day it suggests buyers are losing interest and taking profits sooner.

Whilst you do not need to know the formulae used to work out the indicator, it is useful to how the basis of its

construction so you can apply it to your trading. The indicator usually incorporates two lines, the %K and %D lines which oscillate between 0 and 100. The %K shows the latest close in relation to the average range of the last 14 days. The %D line takes a 3-day moving average of that line.

For ‘slow stochastics’, which is more commonly used, the data is further smoothed by taking a moving average (usually 3 or 5 days) of the moving average. In this situation, the %K line is the 3-day moving average of the simple 14-day stochastics (the original %D line), and the %D line is a 3 or 5-day moving average of the new, ‘slow’ %K line.

Overbought/Oversold

Stochastics is useful in determining whether a market is overextended. Usually, we would say that the security is overbought when the %K moves above 80 and oversold when it falls below 20. As with any indicator of this sort, a security can continue to rise despite being overbought and continue to fall when it is already oversold.

Stochastics ranging between overbought + oversold conditions.

%K is shown in grey and %D is shown in red.

Crossovers

Buy and sell signals are given on crossovers – when the %K line moves above or below the %D line.

When the %K line (which is faster moving and more responsive to short-term movements in price) moves below the %D line, it is considered a bearish crossover. A bullish crossover occurs when the %K line moves above the %D line. This agrees with the premise of using multiple moving averages.

These signals are quite frequent and must be treated with caution – usually, traders look for other conditions to be met before a simple crossover is seen as a strong signal. If a crossover occurs whilst the market is considered overbought or oversold, it can have greater validity. As an example, if a bearish crossover occurs while the stochastics show overbought conditions (i.e. above 80), the trader would then look for a move back below 80 for confirmation.

An example of a bullish crossover, as %K line moves above %D line and out of the oversold territory.

Using the same chart pattern but applying the stochastics indicator in addition to the MACD reveals how the stochastics crossover provides an earlier signal of a trend reversal. This agrees with the principle that momentum leads to price action while moving averages are lagging indicators that follow prices. The delay in the MACD signal is noticeable versus that provided by the stochastics. This is a good example of how it is useful to use more than one indicator, with a particular emphasis on using indicators that are based on different data inputs to derive their signals.

This article of ETX Capital