Greetings, fellow Pro-fundity team members -
5-14-99 Page

1. We have devoted recent Guideposts to technical analysis. A technician studies four input parameters and creates a set of technical indicators in an attempt to predict changes in a stock’s price.
1. Price - The price of a stock is a consensus of trader expectations; where one person agrees to buy and another agrees to sell. The supply/demand lines shift as these expectations change, causing prices to fluctuate. These changes follow trends and are often cyclic, repeating the price patterns.
2. Time - The length of the cycle, or period of the change, is important in understanding the strength of the underlying action. The longer a price change takes, the stronger the change will be.
3. Volume - This measures how intense the change in investor attitudes are. The relative volume accompanying a price change signals the stability of the change. That is, an increasing price with decreasing volume will not likely continue to increase.
4. Breadth - What is the rest of the market, or other stocks in a sector doing? There is strength in numbers and breadth provides an additional information gem.
2. Last week we considered "Oscillators" where the indicator value continually cycles between some top and bottom. The principle upon which oscillators are based is termed "Momentum," a measure of how fast and in what direction the price is changing. Are we gaining or losing momentum?
3. The momentum of a stock price determines whether the stock is "overbought" or "oversold." An "overbought" stock has less money coming in as investors shy away from purchases. The price increase slows and flattens out before moving downward. A stock is termed "oversold" when the price falls too far and buyers reenter the market looking for bargains. We want to buy oversold stocks and sell when they become overbought.
4. We discussed Wilder’s Relative Strength Index (RSI) which is very popular with traders. See the sidebar at the end for an explanation of how it is calculated. The RSI provides upper and lower boundaries to measure just how overbought and/or oversold a price is. The RSI indicator varies between 0 and 100, with readings over 70 considered overbought and under 30 as oversold. This boundary condition makes it easy to identify good "buy" and good "sell" candidates.
5. Many market indicators compare the price strength of a stock with that of its sector or with that of some major index. This is termed a "Relative Strength" indication and helps us understand how a particular stock is doing against its peers. We do not want to confuse Wilder’s RSI with these Relative Strength indicators. The Wilder RSI would be better named if it were called a measure of "internal strength," because it does not compare the stock to anything external.
6. In the following chart we show the price pattern for BMCC, with its RSI in the window below. Notice how the RSI follows the price.
BMCC Price Chart with Wilder's RSI



7. Let’s expand the time scale to better see how the RSI might be used for buy and sell signals. Using the 30 and 70 lines to identify oversold and overbought conditions (the lines on the RSI chart are the 30 & 70 levels), what would the chart tell us? If we owned the stock going into this pattern, we should sell about the fourth week in February, buy back in the first or second week in April and get out again the second week in May. We would have missed a little action in March, but that sequence of trades wouldn’t be too shabby.
BMCC Price Chart



8. Good technical indicators have the "power to contradict!" That means they will signal a forthcoming change before it is evident in the price pattern. They will contradict the price pattern. When we get contradicting signals, we have what is called a "divergence." The RSI is particularly helpful to identify and to take advantage of the messages contained in a divergence. In the next chart we have superimposed the RSI onto the price chart to help make this point. Look carefully to see the 30 & 70 level RSI lines, 70 just above $11.44 and 30 just below $9.56. It may be difficult to see the action with the charts on top of one another, but follow carefully: One line, slanting upward to the right, connects the tops of two peaks on the price chart. This means the price is rising, from one peak to the other. At the same time, however, the corresponding RSI peaks are connected with a line slanting downward to the right. What we see is a divergence. While the price peaks are increasing, the RSI is decreasing.
BMCC Price Chart with RSI superimposed



9. In the chart above, notice what happened to the price after this divergence became apparent. The divergence occurred when the price made a new high that was not confirmed by a new high in the RSI. The price usually corrects in the direction of the RSI, which is exactly what happened above. Consider, as you view the chart, how that information could have helped us get out of our position in March. The following chart illustrates an opposite case, where the falling price diverged with the "higher lows" (an increase) on the RSI line. Look where the price went after this divergence.
PLCM price chart with RSI divergence
10. Next week we will study the Moving Average Convergence/Divergence (MACD) indicator. This is the oscillator that follows the trend, having value in both choppy and trending markets. We decided to treat this by itself because of its importance and deal with Stochastics and On Balance Volume in following Guideposts. Stay tuned.

 
Sidebar - Wilder's Relative Strength Index Calculation:

RSI-5

May 21 - Moving Average Convergence/Divergence (MACD)

May 28 - On Balance Volume(OBV)

June 4 - Stochastics

June 11 - TC-2000 proprietary indicators (BOP, MS, TSV)

It is our intent to help our readers understand market strategies well enough to make informed decisions and understand the risks.

We provide TC-2000 tutorials to members. See the Member Login page.