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| RSI
Trendlines and Support/Resistance |
In recent educational articles I have explored several
facets of how RSI can help the swing trader predict a stock's behavior.
Here is a list of the important ideas we have discussed so far:
-- 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 (AL, $45.60) 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.
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