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| The
Limitations of RSI |
In our last several educational articles I have explored
RSI in depth. Along the way, I sincerely hope you have gained a deeper
appreciation of how RSI can help you spot swing trading opportunities.
Daily RSI is an extremely valuable tool in the swing trader's toolkit
because it anticipates changes in the underlying price chart. Traders
can analyze RSI using trendlines and price patterns. These trendlines
and patterns often form ahead of changes in the underlying price chart.
At oversold or overbought levels, RSI can warn of bullish or bearish
divergence. This divergence signifies that a stock is losing momentum.
Since momentum peaks before price, RSI is warning that a reversal may be
imminent. Subsequently, if RSI creates a "failure swing," then
it gives a clear signal to enter a long or short position.
Is RSI then the "perfect" indicator? Definitely not! As
helpful a tool as it is, RSI has several limitations. Focusing on these
limitations does not denigrate the value of RSI. Instead, it merely
warns the swing trader to apply this technical tool with discretion.
Mechanical judgments are to be avoided. Technical analysis is both an
art and a science. Ultimately, the technician must be a master of his or
her tools and not a slave to them. In previous "Inside The Black
Box" articles I have shown examples of where RSI worked very
effectively. In today's installment, however, I want to point out the
fact that RSI does not hit a homerun every time.
What limitations of RSI should the swing trader be aware of? There are
four major ones that I think you should be alert to:
-- RSI can get overbought early in a trend and stay that way for long
periods of time. In a strong up or downtrend, RSI will quickly reach the
overbought 70 level or oversold 30 level. A swing trader seeing a stock
close to 70 or 30 may decline to take a position. Worse yet, the trader
may dance close to the exit door and take profits prematurely. However,
it's important to remember that RSI can stay at overbought levels for
weeks and even months at a time.
-- Bearish and bullish divergence warns the swing trader that a trend is
losing force. However, this divergence can persist for long periods
before the stock actually declines.
-- The failure swing constitutes an RSI buy or sell signal. In my
experience, failure swings are accurate in the large majority of cases.
However, there are occasions where the failure swing signal is reversed
and RSI rallies back to an overbought or oversold level, whipsawing the
trader.
-- RSI can move trendlessly over long periods of time. In these
instances it gives no clear message. The indicator is then not
misleading; it is simply of little value.
I suggested watching VeriSign (VRSN, $$28.13) from a short perspective
in our January 19th Swing Trader issue. The stock illustrates some of
the pitfalls of applying RSI analysis mechanically. VRSN began a very
strong uptrend in late September just under the $20 mark. In mid-October
it gapped above $25 on enormous volume after the company released
earnings. RSI, which had been hovering near 70, moved decisively over
the 70 mark at this time.
Over the course of the next month, VRSN entered into a
stair-step uptrend that took the shares to a peak of $36.09 in
mid-December. Note how RSI held above the overbought 70 level for
virtually that entire period (except for a few days in mid-November). A
swing trader following RSI exclusively would have missed the move in the
stock.
Second, note the bearish divergence from mid-November through to the
stock's peak in mid-December. Interestingly, this bearish divergence
gave an accurate warning, but one which lasted an entire month. Again,
following RSI exclusively would have led to incorrect trading decisions
here.
Third, note in early December how RSI completed a bearish failure swing
after the bearish divergence. If the swing trader had gone short on that
signal, then he or she would have needed to hold the stock short as it
rallied from $32 to just above $36. That probably would have triggered a
stop loss and created a trading loss as well. If shorted at $32, then it
wasn't until early January that the trade finally turned profitable.
Finally, note in late December as the stock moved sideways, RSI did the
same. This trendless activity in the stock was echoed by RSI during this
period. As such, the indicator did little to clarify the situation.
Given the limitations in RSI, is there a tool that would
have allowed judgments to be made with more accuracy? My answer is the
simple trendline. Note how a trendline drawn off the late September
bottom held until mid-December. If the bearish divergence and
trendline break were combined, then the swing trader would have taken a
short position near $32 a few days before the end of the month. While
four or five days premature, the short would have paid off handsomely in
January.
RSI, like all indicators, is a mechanical tool based on a mathematical
calculation. In the large majority of cases it allows the trader to
analyze a stock with much greater insight than if it were not used at
all. However, swing traders need to remember to be a master of their
tools, not a servant to them. Like all other indicators, the directives
of RSI should be applied with discretion.
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