Technical Analysis Tools: RSI and MACD


There are a several tools and indicators used for technical analysis of stocks. However, it is not advisable to make decisions solely on single technical analysis tool. RSI and MACD are NOT based identical methodology. So, if both of them agree on a recommendation then it just might form a good foundation for making the Buy/Sell decision.

Relative Strength Index (RSI) 


RSI, documented in New Concepts in Technical Trading Systems by J. Welles Wilder, measures the velocity or directional price movement as smoothed & normalized 0-100 range bound momentum oscillator. It's a representation of ratio of:
    "Average of day-to-day gains(up closes) for N days" / "Average of day-to-day losses(down closes) for N days"

  Assuming N=14-period RSI,
    A 0 RSI value means prices moved lower all 14 periods. There were no gains to measure.
    RSI value 100 means prices moved higher all 14 periods. There were no losses to measure.

The slope of the momentum oscillator is directly proportional to the velocity of the move. The distance traveled up or down by the momentum oscillator is proportional to the magnitude of the move.

The RSI oscillator appears to be one step ahead of the price graph; the reason being that the oscillator, in effect, is measuring the rate of change of price movement.

Note: RSI itself is NOT an overbought/oversold indicator.

Failure Swings (W/M pattern) as "Confirmation" for Buy/Sell signal

Wilder considered failure swings as strong indications of an impending reversal. A "bullish failure swing" forms when RSI moves below 30, bounces above 30, pulls back but holds above 30 and then breaks its prior high (Pattern "W" with the right bottom of W above left bottom). A "bearish failure swing" forms when RSI moves above 70, pulls back (below 70), bounces but fails to exceed 70 and then breaks its prior low (Pattern "M" with the right top of M below left top).

TODO Question:
What is the precise condition for RSI BUY CONFIRMATION? Is it making the W pattern "ABOVE RSI 30", "ACROSS RSI 30" or even "BELOW RSI 30"? (See "W" for Symbol "IDFC" on 2013 Aug 30, Sep 2, 3, 5 at http://www.stockmarketindian.com/technical_charts/free_technical_charts_analysis.html).
Similarly, What is the precise condition for RSI SELL CONFIRMATION? Is it making the M pattern "BELOW RSI 70", "ACROSS RSI 70" or even "ABOVE RSI 70"?

RSI Trend range, Support & Resistance

Constance Brown suggests that, RSI tends to fluctuate between 40 and 90 in a bull market (uptrend) with the 40-50 zones acting as support. RSI tends to fluctuate between 10 and 60 in a bear market (downtrend) with the 50-60 zone acting as resistance. These ranges may vary depending on RSI parameters, strength of trend and volatility of the underlying security.

RSI Divergence

Wilder suggested Divergence signals a potential reversal point because directional momentum (RSI) does not confirm price. A bullish divergence occurs when the underlying security price makes a lower low and RSI forms a higher low (Is it typically, starting below 30 going above???). RSI does not confirm the lower low and this shows upcoming strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high (Is it typically, staring above 70 going below???). RSI does not confirm the new high and this shows upcoming weakening momentum.
NOTE: Divergences may be MISLEADING in a STRONG trend. See "Positive-Negative Reversals" for better/improved recommendations.

RSI Positive-Negative Reversals

Andrew Cardwell's interpretation of divergences differs from Wilder. Cardwell considered bearish divergences (in RSI 30-50 range) in bull market are likely to form uptrends (as if RSI is temporarily stepping down just to build strength to surge up). Similarly, bullish divergences (in RSI 50-70 range) in bear market are more likely to form a downtrend.

A positive reversal forms when RSI forges a lower low (in range above 30 up to 50), but the security price forms a higher low. Even if RSI shows weak momentum (downtrend), the price action in bullish market failed to confirm and continues to form higher low probably breaking resistance and climbing high.

A negative reversal forms when RSI forges a higher high (in range below 70 down to 50), but the security price forms a lower high. Even if RSI shows strong momentum (uptrend), the price action in bearish market failed to confirm and continues to form lower high probably causing a big support break (fall).

RSI References


RSI: http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:relative_strength_index_rsi
Failure-Swing points: http://www.investopedia.com/articles/technical/03/042203.asp
Various types of Failure-Swing points: http://www.thepatternsite.com/failswing.html
Divergence: http://www.investopedia.com/articles/trading/08/price-momentum.asp

The Relative Strength Index is a Momentum Oscillator, it's NOT an Overbought/Oversold Indicator:
http://www.technical-analysis.com/learnTA/RSIisMtmOsc/RSIaMtmOsc.html
http://www.technical-analysis.com/learnTA/RSINotOBOS/RSINotOBOS.html


MACD (Moving Average Convergence/Divergence)

Gerald Appel developed the MACD indicator in an attempt to chart momentum by measuring the increasing and decreasing space between two exponential moving averages. MACD is an absolute price oscillator (APO), because it deals with the actual prices of moving averages rather than percentage changes. MACD line shows the difference between a "fast" (short period) exponential moving average (EMA), and a "slow" (longer period) EMA. The "signal line" or "average line" is day EMA of the MACD line itself. By comparing EMAs of different periods, the MACD line can indicate changes in the trend of a stock. Typical MACD parameters MACD(faster, slower, signal) are MACD(12,26,9).

    MACD = EMA(stockPrices, 12) - EMA(stockPrices, 26)
    signal = EMA(MACD, 9)
    histogram = MACD - signal

One popular short-term set-up is MACD(5,35,5).

A crossing of the MACD line through zero happens when there is no difference between the fast and slow EMAs. Zero crossovers provide evidence of a change in the direction of a trend but less confirmation of its momentum than a signal line crossover. The standard interpretation is to buy when the MACD line crosses up through the signal line, or sell when it crosses down through the signal line. See "MACD Channels" for better recommendations for Sell action.

Note: As a metric of price trends, the MACD is less useful for stocks that are not trending (trading in a range) or are trading with erratic price action.

MACD Channels

To create the MACD channel, draw "support line" by connecting the bottoms and draw the "resistance line" by connecting the tops of the MACD. MACD Channel divergent with the security price indicates that something is changing. Sell action should be taken when MACD reaches/breaks the channel support.

MACD References

http://en.wikipedia.org/wiki/MACD
http://www.investopedia.com/terms/m/macd.asp
https://www.istockanalyst.com/help/MACD
MACD Channels & Divergence: http://www.investopedia.com/articles/trading/09/spotting-trend-reversals-macd.asp


Reference Videos


How To Use MACD / RSI to Spot Changes In Market Momentum (15min):
http://www.youtube.com/watch?v=adSGUkNX5LA

MACD and RSI trading strategy (1hr, not yet watched):
http://www.youtube.com/watch?v=8Kx-Le56BmM


LIC Housing Finance - Technicals experiment

This experiment is "work in progress":

http://www.stockmarketindian.com/technical_charts/free_technical_charts_analysis.html
Stock Symbol: LICHSGFIN
Click Update

Chart readings

24-Jul: RSI(14) Below 30. ==> RSI BUY INDICATION
8-Aug: RSI Failure Swing Point (Bottom), if W pattern is considered from below 30 to up.. ==> RSI BUY CONFIRMATION (correct interpretation or hindsight?) (MP 168)
12-Aug: MACD(26,12) crossover above > signal line EXP(9) ==> MACD BUY SIGNAL (MP 175.70)
26-Aug: RSI Failure Swing Point (Bottom) around RSI 41.31 due to W made on 26-Aug higher high RSI 45.87 after 14-Aug first high RSI 41.31, then higher low 20-Aug RSI 30.82. ==> RSI BUY CONFIRMATION. (MP 176.40)

It is recommended to use two tools (RSI & MACD) each supporting the Buy/Sell action to be taken. So, actual BUY action became valid on 12-Aug or 26-Aug based on how RSI Buy Confirmation is detected.

Started studying RSI/MACD on 10-Sept.
10-Sept: RSI(14) 56.60. Cross from below to above 50 line ==> BULLISH. Check, if this is true!
10-Sept: MACD(26,12)=-4.924 (Note, It's NOT above zero line. Check, if this matters!)
11-Sept: LTI 25%=188.99 (52 hilo: 300.00, 152.00)
11-Sept: Buy MP 187.50 [About 15 days after the BUY CONFIRMATION trigger, "costlier" by Rs11 (187.50-176.40)], or [About 1 month after the BUY CONFIRMATION trigger, "costlier" by Rs12 (187.50-175.70)].


Or Is it [About 1 month after the BUY CONFIRMATION trigger, "costlier" by Rs19 (187.50-168)] if only RSI (8-Aug) is considered to be sufficient?


NOTE:
MACD is not above zero (-4.924). So, it is yet to clear the resistance level (zero line). Let's observe if LTI 25%=188.99 acts as the zero resistance/support line.
12-Sept: CMP 181 (down from 187 as expected due to MACD below zero line). Now, even though price dropped, MACD is closer to zero at -2.145.

Sell Signals

1. (a) BEARISH/SELL SIGNAL when MACD(26,12) crossover below < signal line EXP(9), or (b) SELL when MACD breaks channel. Check, if option (a) is "not applicable at all", and that it's better to follow option (b).
2. RSI SELL INDICATION above 70 followed by SELL CONFIRMATION (M pattern failure switch above 70).
 
 

Moving Averages (SMA & EMA)

 
A Simple Moving Average (SMA) is formed by computing the average price of a security over a specific number of periods.

Exponential Moving Averages (EMA) reduce the lag by applying more weight to recent prices and are therefore more sensitive to recent prices and recent price changes.
 
Exponential moving averages will turn before simple moving averages. Simple moving averages, on the other hand, represent a true average of prices for the entire time period. As such, simple moving averages may be better suited to identify support or resistance levels.
 

Price Crossover


200-day, 50-day and 5-day Moving Average could be used for indicating the Long-term, Medium-term and Short-term trend respectively. A bullish signal is generated when prices move above the moving average. A bearish signal is generated when prices move below the moving average. The longer the moving average periods, the greater the lag in the signals. These signals work great when a good trend takes hold.
 

Double Crossover

Two Moving Averages can be used together to generate crossover signals. A system using a 5-day EMA and 35-day EMA would be deemed short-term. A system using a 50-day SMA and 200-day SMA would be deemed medium-term, perhaps even long-term. A moving average crossover system will produce lots of whipsaws in the absence of a strong trend.
 
 
Moving averages are trend following, or lagging indicators that will always be a step behind. Moving averages should not be used on their own, but in conjunction with other complementary tools.
 

 

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