Several facets of how RSI can help the swing trader predict a stock's behavior?
- When RSI goes above 70 or below 30, it indicates that a stock is overbought or oversold and vulnerable to a trend reversal.
- A reversal often occurs after bullish or bearish divergence. Bearish divergence takes place when the stock makes a new high, yet RSI makes a lower high. Bullish divergence occurs when a stock makes a new low, yet RSI makes a higher low.
- An RSI failure swing provides a trading signal. A bearish failure swing occurs when RSI peaks above 70, goes below that level, tests the first peak, fails, and breaks support on the RSI chart. The bullish failure swing is the reverse.
- RSI forms patterns such as triangles or head and shoulders top and bottoms. Breakouts from these patterns on the daily chart often precede the price breakout by one or two days, providing the swing trader valuable advance notice. As we have seen, these four features of RSI often come together to create a high-probability buy or sell signal. Thus, a stock may go over 70, create bearish divergence, form a descending triangle top and then complete a failure swing. These signals often predict the signal on the price chart.
- Now I want to discuss the final RSI concept mentioned in Welles Wilder's book New Concepts in Technical Analysis -- that "trendlines on the bar chart often show up as support lines on RSI." A corollary of this point, not mentioned by Wilder, is that the RSI line itself is susceptible to trendline analysis. A break in the RSI trendline often provides a signal, which often predicts that of the price chart.The chart of Alcan provides a good example of why the swing trader should pay attention to RSI trendlines and support levels. Alcan began a strong uptrend in late July 2004 at $38.07. The stock climbed steadily for several months and hit a peak of $52.65 in mid-November. From there, it declined to just under $50, rallied to a slightly lower low at $50.26 and declined steeply in early December.Note the behavior of the RSI line during the uptrend. Several times it reached overbought levels, but on pullbacks the stock found support just under $50. This behavior supports Wilder's observation that during an uptrend the RSI will create its own support level.
Just as an uptrend line can be drawn underneath price action, an uptrend line can be drawn underneath the RSI. That line starts in late July at the oversold 30 level and breaks at the very end of November -- providing one day's warning of the break of the uptrend line on the price chart. Immediately after that, on the first trading day of December, RSI broke its support level, providing confirmation of the trendline break on the price chart. Subsequently, Alcan fell about $3 per share to $46.15.
When Alcan reached support near $46, the stock began a minor rally in mid-December. An uptrend line can be drawn on both the price chart and the RSI line. A downtrend line started on the RSI line at the early November peak of $52.65 exactly intersects with the highest point reached by the RSI line and marks the exact point where the Minor uptrend hits its price peak. A parallel trendline can not easily be drawn on the price chart, so RSI analysis gave a warning otherwise unavailable. The RSI break down from a symmetrical triangle coincides with a sharp drop in the stock. On Thursday, Alcan's RSI went below 30, showing the stock was oversold. The stock has support near $45 and swing traders should be alert to a bullish failure swing forming in the next several days.RSI trendlines and support levels supplement the four major tenets of RSI analysis described at the beginning of this article. This analysis adds additional power to an already robust indicator.
