Relative Strength Index (RSI)
While bonds have been trending aggressively over the last few months in a Bear Market (yield), equities seem to be very directionless or sitting in a deer market. A deer market is a term used to illustrate a market condition when investors are unable or unwilling to move due to uncertainty - like a deer who freezes when "caught in the headlights" of a vehicle.
To an investor this is usually a good time to do nothing; to sit on the sidelines and wait for a clearer indication of what is to come. However, for traders like those at Futex, sitting idly on the sidelines is not an option. Our traders have overheads to pay, mouths to feed at home and must therefore be adept at making money at all times of the year and in all types of markets.
So, how exactly does a trader trade a range-bound market and what are the common technical indicators or tools they use in such a situation?
Well, through repeated deliberate practice, Futex traders develop an instinctive ability to adapt in real-time to the market that exists in front of their eyes. By being heavily involved in the markets on a daily basis, and fighting to extract ticks wherever possible, they naturally amend their style to fit the prevailing conditions. For example, profit expectations may be reduced on a per trade basis; the duration of trades may increase compared to an individual’s average; and the frequency of breakout-type trades may be reduced.
One technical indicator used by some of our traders in range-bound markets is the relative strength index or RSI. The Relative Strength Index was developed by J. Welles Wilder and published in a 1978 book, New Concepts in Technical Trading Systems, and in Commodities magazine (now Futures magazine) in the June 1978 issue. The actual indicator is classified as a momentum oscillator that compares the degree of recent gains to recent losses in order to ascertain the overbought and oversold situation of a particular product or asset. The indicator is considered to be overbought if it gives a reading above 70 and oversold if below 30. However, one of the most powerful signals that RSI can generate is divergence. A bearish divergence forms when the price of the product or asset makes a new high while the RSI indicator makes a second, lower high confirming a slowdown in the momentum of the prevailing move. A bullish divergence, by contrast, forms when the price of the product or asset makes a new low while the RSI indicator makes a second, higher low.
This technical indicator provides a very useful backdrop to our traders’ decision making; it helps provide context to the intra-day information upon which they make their high-frequency trading decisions. However, as with all technical tools, the skill lies in understanding the tool being used and its effective implementation. While many traders make use of the RSI, it is important to note that large surges and drops in the price of a product will have an adverse impact by creating false buy or sell signals. Therefore, like any other technical indicator it is best used to complement other trading tools, techniques and ideas, and is not a solution in isolation.
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September 3rd, 2010 at 8:53 am
Personally I have always avoided such technical indicators when it comes to discretionary trading, with the strong held belief that they have in fact nothing to do with the auction process and that applying “maths” to the price and volume is like looking at the market through coloured specs rather than just looking at what is really there. (credit to Schwager for the coloured specs analogy). A very similar yet more relevant concept to the auction process is the idea that the value area, which is calculated as the first standard deviation and thus contains 70% of the days trading volume should be followed. The last time I was buying something and considering its value the idea of 70% never entered my mind. As for RSI and indeed other so called leading indicators although I accept the point that it is used to complement orderflow, personally I have found that more information does not necessarily lead to better decisions. (J. Welles Wilder book is a heavy read if my memory serves me correctly but well worth it if you’re an algo system developer)
Please note this is not intended as an arsey reply I look fwd to the inbox education instalments and find them of great interest. I just thought I would interact and see what happens!
September 13th, 2010 at 7:23 am
Thank you very much for your considered response and for interacting with the blog. Similarly, many of our traders use limited amounts of technical analysis in their day-to-day trading and you are absolutely right to suggest that too much technical analysis often leads to trading decision paralysis. Those individuals that join Futex are trained to make effective trading decisions using amongst other things the order flow, global news flow, macroeconomics, correlated market information and “some” technical analysis. In fact, technical analysis represents roughly 10% of the information upon which trading decisions are made. RSI is one of the many other indicators out there which “can” help if used effectively alongside the other elements mentioned. I agree with you that the Market Profile to which you allude is one of the most effective techniques new traders can learn that has a very positive impact on market understanding and thus trading. The auction process and the market’s perception of fair value serve as very useful metrics for gauging buying and selling pressure, supply and demand, bullishness and bearishness and, more importantly, market neutrality or sideways rotation. Thanks again and good luck in your trading.