Schwab Investing Insights Trading Edition Text Close Window Size: November 15, 2007

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1 Schwab Investing Insights Trading Edition Text Close Window Size: from TheStreet.com November 15, 2007 ON TECHNIQUES Two Indicators Are Better Than One The Relative Strength Index works well but it s better in conjunction with Bollinger Bands. By Dan Fitzpatrick TheStreet.com Contributor The Relative Strength Index (RSI) is a valuable secondary indicator. But the RSI works best when a stock is trading in a range. Use Bollinger Bands to help determine when the RSI will be most useful in analyzing a stock s price movement. Many traders rely on secondary indicators for confirmation of what they are seeing in the price action. There is a certain appeal in using indicators such as stochastics, the Moving Average Convergence/Divergence reading (MACD), the Relative Strength Index (RSI) or any of the many volume-based indicators, such as money flow or on-balance volume, to add to the analytical process. After all, a trader wants every possible edge in order to succeed, and using a number of indicators can be quite helpful in making the transition from looking at what was to forecasting what may be. While secondary indicators are indeed helpful for assessing the quality of the price action, most traders never really consider a critical aspect of these indicators: that they do not universally apply to all price dynamics. That is, some indicators are designed to augment the analysis of the trend, while others work best to analyze trading channels. J. Welles Wilder s RSI is a great example of this. In simple terms, the RSI is calculated by comparing the closing price to prior closes. Advancing prices tend to close nearer the high of the day, and falling prices tend to close nearer the low of the day. The RSI is a bounded oscillator, ranging from zero to 100. A reading above 80 is an indication of a stock s overbought status, while a reading below 20 is an indication of a stock being oversold. (1 of 7)11/20/2007 3:05:19 PM

2 The RSI works best in a trading range. When a stock is bouncing up and down within a defined channel, the RSI enables us to compare the sequence of peaks and troughs. Is the upward momentum increasing or decreasing with each successive peak? Is the downward momentum of each successive trough increasing or decreasing? This information helps us gauge the quality of the price action: Successively higher RSI readings tend to accompany a stock that is picking up steam and is likely to break out of a trading range. Successively lower RSI readings are indicative of increasing weakness and often precede breakdowns from trading ranges. The RSI has more limited usefulness during trends. Strong uptrends should be accompanied by overbought RSI readings, while strong downtrends typically produce oversold RSI readings. So these extreme conditions typically tell us what we already suspect. But most price charts stubbornly refuse to tell us when they are making the transition from being range-bound (where the RSI is useful) to trending (where the RSI is less useful), so we need some objective criteria for determining whether the RSI signal is worth paying attention to. That s where Bollinger Bands can come in. I ve previously covered Bollinger Bands, so please refer back to Price Patterns Are All Relative if you have any questions about them. Using Bollinger Bands in conjunction with the RSI is straightforward. When price is ranging through the entire Bollinger Band s width from the bottom band to the top band we consider the price to be in a trading range, and the RSI is expected to be useful. But when price is contained by just one half of the bands say, in the top half, between the middle and upper band then we consider the stock to be trending, negating the usefulness of the RSI. Let s take a look at the S&P 500 Index through a series of four different time frames and see how the usefulness of the RSI changes. (2 of 7)11/20/2007 3:05:19 PM

This chart shows a series of complete price oscillations in early 2006 during January through early May. The S&P was bouncing from the lower Bollinger Band to the upper band.

3 This chart shows a series of complete price oscillations in early 2006 during January through early May. The S&P was bouncing from the lower Bollinger Band to the upper band. It was in a trading channel. And each tag of the upper and lower Bollinger Band was accompanied by a well-defined top or bottom in the RSI at the same time. So during the time that the S&P was in a price channel, the RSI was useful in confirming price tops and bottoms. But this changed in mid-may. The S&P once again tagged support at the lower Bollinger Band and the RSI fell back to the low edge of the channel. But rather than bounce as it had done the previous four times, the S&P broke out of the channel. Over the next month, the S&P was in a downtrend, remaining below the middle Bollinger Band. During this time, the RSI wasn t telling us anything we couldn t see by simply watching the price action. Let s fast-forward another month to mid-july. (3 of 7)11/20/2007 3:05:19 PM

4 I ve highlighted the sequence of price troughs and peaks that serve to indicate a new trading channel. Once the S&P has run from one band to the other and back again, we consider the price action to be range-bound. We can once again start quantifying the price action using the RSI. Let s fast-forward another month: (4 of 7)11/20/2007 3:05:19 PM

5 I ve continued the price channel into mid-august, when the S&P ran back up to the July high and confirmed the trading channel. At that time (marked by #4), we can see how the RSI is again in a defined channel right along with the price action. We can also see that the early August pullback in price halted at the middle Bollinger Band the middle of the trading range. At the same time, the RSI also fell to the middle of the range. The ensuing breakout is a bullish sign, but there is no real confirmation by the RSI we still need a higher high. (5 of 7)11/20/2007 3:05:19 PM

Finally, in late August we have a higher high in the RSI, accompanied by a higher high in the price action. But after that confirmation, we no longer need the RSI to keep us in the game.

6 Finally, in late August we have a higher high in the RSI, accompanied by a higher high in the price action. But after that confirmation, we no longer need the RSI to keep us in the game. As long as the S&P continues to run between the middle and upper Bollinger Bands, we really don t need a bounded oscillator to tell us the price is overbought. Focusing on the RSI during such an obvious uptrend is akin to continually firing the starting gun after the racers have left the blocks. All you needed was one shot to get the race started. After that, you re just wasting bullets. Bottom line As you analyze your stock charts, try using these concepts to frame your analysis. Don t just automatically use the RSI to assess price action. Instead, first decide whether the stock is range-bound or trending. If it is rangebound, add the RSI to your analysis. You ll have a clearer idea of when the price breaks out of that range. But if the stock is trending, don t focus on the RSI focus on the trend using Bollinger Bands. Only after that trend ends is it time to bring the RSI back into the mix. Important Disclosures: Neither Mr. Fitzpatrick nor TheStreet.com is affiliated with Charles Schwab & Co., Inc. The views expressed here are those of Mr. Fitzpatrick, and do not necessarily reflect the views of Charles Schwab & Co., Inc. They (6 of 7)11/20/2007 3:05:19 PM

7 are presented as a service to Schwab Active Trading clients. Schwab makes no judgment or warranty with respect to the accuracy, timeliness, completeness or suitability of the information presented. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Schwab does not recommend the use of technical analysis as a sole means of investment research. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CSA ( ) ELC (11/07) (7 of 7)11/20/2007 3:05:19 PM

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OSCILLATORS. TradeSmart Education Center OSCILLATORS TradeSmart Education Center TABLE OF CONTENTS Oscillators Bollinger Bands... Commodity Channel Index.. Fast Stochastic... KST (Short term, Intermediate term, Long term) MACD... Momentum Relative