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| RSI: The
Failure Swing |
RSI: THE FAILURE SWING
In last week's educational article I
discussed bullish and bearish RSI divergence.
Bullish divergence occurs when a stock or index makes an equal or lower
low in price but the RSI indicator makes a higher low. Bearish
divergence is just the opposite -- price makes an equal or higher high,
but RSI makes a lower high. Bearish divergence is marked by a rising
trendline above the price action and a falling trendline on the RSI
indicator.
As we saw last week, the reason this divergence occurs is built into the
calculation of RSI. Given that the formula divides the average up closes
by the average down closes, when consolidation occurs after a strong
move up, the RSI line will decline. It does so because the average days
up/average days down figure decreases. The reverse happens when there is
a consolidation after a downtrend.
Welles Wilder, the designer of RSI, referred to a special case of RSI
divergence as a "failure swing." Although the swing trader
must generally wait for a signal from the underlying price chart -- such
as a trendline break or moving average crossover -- after spotting RSI
divergence, the failure swing generates a buy or sell signal in and of
itself.
A bearish failure swing occurs in the following manner. First, RSI rises
to an overbought level above 70. For the sake of example, let's say RSI
reaches a peak of 74. RSI then declines. This fall can either bring RSI
down below the overbought 70 level, or it can merely bring RSI back
toward 70. In our example, we'll assume the RSI line retreats to 62. As
Wilder points out, this movement toward 62 can be comprised of several
minor up and down fluctuations.
In the next stage of the failure swing, RSI rallies. However, the
indicator reaches a second peak that is lower than the first peak. In
this example, let's say it reaches 68. On the next decline, RSI breaks
the previous low at 62. This break below 62 completes the failure swing.
As soon as this happens, the stock has given an RSI sell signal and the
swing trader should go short.
(Please note that a bullish failure swing is simply the reverse of what
I've just described. First RSI will fall below 30, then rally, decline
back toward 30, and then break out above the previous high.)
What I've just described is akin to a trend reversal on a price chart.
Trend reversal after a rally consists of a peak, a decline, a second
peak that ends up lower than the first, and finally a break below the
level of the first decline. The reverse is true when the trend changes
from down to up. Typically, the trader can see the letter "M"
in a bullish-to-bearish trend reversal and the letter "W" in a
bearish-to-bullish reversal. The "M" and "W" are
also distinguishable on the RSI chart.
You can see both bullish and bearish divergence on the chart of
for-profit education company Apollo Group (APOL, $79.51) below. Bullish
divergence occurred in August when, after a prolonged price decline,
APOL held support at 70. During this consolidation RSI hit a low beneath
30, rallied and then declined. The buy signal came when RSI moved above
its previous high point. Note that APOL gave this buy signal during its
consolidation period prior to gapping sharply higher in late August.
Although the "W" is irregularly shaped, it can be seen in the
RSI pattern.
Bearish divergence occurred at the beginning of
December. First, Apollo hit resistance near $85. The RSI line then
formed a peak, declined, hit a lower peak and then gave a sell signal
when it fell below the previous low. The failure swing this time was
completed when APOL gapped down from $85 to $80. Bearish RSI divergence
had warned the swing trader who held this position long that the time to
nail down profits had arrived.
RSI divergence and the failure swing are closely related
concepts that work together hand in hand. Together they can be used to
spot opportune times to claim profits or reverse positions. In our next
"Inside the Black Box" educational article I will show how
price patterns such as triangles formed by the RSI line can alert the
swing trader to impending changes in a stock's price.
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