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| RSI
Patterns |
RSI PATTERNS MIRROR AND
ANTICIPATE CHART PATTERNS
In previous issues, we have explored the logic of the RSI
calculation, bearish and bullish divergence and the failure swing. I
want to now highlight how chart patterns formed by the RSI indicator
mirror and anticipate price patterns in the underlying stock chart. By
paying attention to RSI, the trader can, as Wilder notes, spot
"chart formations not obvious on a bar chart." Further,
RSI sometimes gives a signal one or two periods in advance of the price
chart. That warning can provide valuable lead time to take a position in
the stock or be primed to do so as soon as the price chart begins to
confirm the RSI signal.
As previously discussed, RSI is calculated by taking an average of up
and down closes for the past "n" periods, often 14 days. This
calculation is then plotted on a panel above or below the price chart.
The patterns formed by RSI can both mirror and anticipate underlying
chart patterns. Since RSI is plotted as a point, it creates a line chart
instead of a candle or bar chart. These line graphs dictate the kind of
patterns RSI form. The formations that I find most common are head and
shoulders tops and bottom and triangles of all varieties. Occasionally,
rectangles and other formations such as wedges occur.
The head and shoulders can be formed over a very short period of time --
such as four or five days -- in which case a Minor top in the stock is
likely. The head and shoulders should be watched particularly carefully
if it forms above the overbought 70 level or the inverted head and
shoulders forms below the oversold 30 level. The head and shoulders top
is often accompanied by bearish divergence, as the stock's price makes a
nominal new high while the RSI indicator hits a lower peak. Sometimes
the RSI head and shoulders formation can form over several weeks or
months. These are far more significant patterns and can signal important
Intermediate reversals on the price chart. Often they will warn of and
correlate with an Intermediate trendline break on the price chart.
RSI is calculated so that support and resistance levels in the indicator
have technical significance. Trendlines can also be drawn on the RSI
line. The combination of support and resistance with a trendline means
that RSI frequently forms symmetrical, ascending and descending
triangles. Occasionally, rectangles also emerge on the RSI chart. Less
frequently, RSI will form pennants and wedge formations. Again, these
formations typically can be spotted more clearly on the RSI chart than
the price chart and often precede the action in the price chart by one
or two periods.
On the chart below of precious metals stock Barrick Gold (ABX,
$24.22), I have marked five underlying price patterns and correlated
them with five RSI patterns:
• 1: A symmetrical triangle formed in ABX between
mid-August and mid-September. At the same time, RSI created a descending
triangle. The breakout in RSI occurred two days before the breakout in
price, giving the swing trader ample notice that a rally was imminent.
Note how RSI held support as prices moved higher in late September. That
is a common pattern in RSI.
• 2: After the breakout ABX moved quickly from near $20 to $22 and
then stalled. A minor topping pattern in price was mirrored by a small
head and shoulders top in RSI above the overbought 70 level. The break
in RSI below 70 was followed by a retreat in the stock price back toward
the breakout level of $20.
• 3: In mid-October ABX recovered to a new high near $22.80. RSI
formed another small head and shoulders formation.
• 4: In early November ABX retreated to $21 and then began a steep
uptrend which carried the stock north of $25. The RSI line rallied
sharply and became overbought. Several RSI signals then strongly
announced that profits should be taken.
There was bearish divergence, as price went higher while RSI made a
second lower high. RSI formed a double top pattern. This double top is
far more clearly seen in the RSI chart than the daily price chart. The
RSI trendline was then broken and a failure swing occurred. A failure
swing, discussed in Inside The Black Box of December 17th, is an
RSI sell signal. Note the failure swing signal occurred one day before
the steep price trendline was broken. The swing trader who paid careful
attention to RSI received an early warning of the impending price
movement.
• 5: After the steep trendline was broken on the price chart, ABX
retreated to the low $22 range, holding the Intermediate uptrend line
that had begun in mid-August near $18. RSI retreated to support in the
mid-40's on its own scale, a level it had not fallen below since
mid-August, near when the rally in the stock's price began.
A very large head and shoulders pattern can now be
discerned in the RSI chart, with the head formed in mid-November, the
left shoulder in early October and the first part of the right shoulder
in early December. A break below 45 on RSI would almost certainly
forewarn of a break of the Intermediate trendline on the price chart,
setting up a highly profitable shorting opportunity in ABX. I will be
monitoring ABX's RSI and price chart and keep you informed if this
breakdown occurs.
RSI price patterns, when combined with the tools of divergence and
failure swings, can give powerful warnings of future movement on the
price chart a day or two in advance. Swing traders should make a habit
of carefully monitoring the message of the RSI line, in order to clarify
and anticipate changes in the price chart.
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