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Something I've Learned Trading Relative Strength Since the 1990s Thumbnail

Something I've Learned Trading Relative Strength Since the 1990s

When I started studying tactical trading for investment portfolio management going on thirty years ago, one of my favorite books was New Concepts in Technical Trading Systems by J. Welles Wilder published in 1978 and written on graph paper. To this day, having read over 500 tactical trading related books since then, I still think it was one of the best.

Wilder introduced the Relative Strength Index (RSI), Average True Range (ATR), and Average Directional Index (ADX) and Directional Movement Index (DMI) succinctly and it resonated with me. I went on to systematically test these indicators and develop my own variations.

In that one little red book, he introduced me to some concepts I consider core to trading systems. 

Average True Range (ATR) is the average of true ranges over the specified period. ATR measures volatility, taking into account any gaps in the price movement. The Turtle Traders trained by Richard Dennis and William Eckhardt used ATR to normalize the size of their positions across global markets. I use ATR to define the normal noise of the market as part of my exit systems. 

Average Directional Index (ADX) and Directional Movement Index (DMI) are used together. Wilder’s DMI (ADX) consists of three indicators that measure a trend’s strength and direction. Three lines compose the Direction Movement Index (DMI): ADX (black line), DI+ (green line), and DI- (red line). The Average Directional Index (ADX) line shows the strength of the trend. The higher the ADX value, the stronger the trend.

Relative Strength Index (RSI) is a momentum indicator used measure the speed and magnitude of recent price changes to evaluate overvalued and overbought or undervalued/oversold conditions in the price trend. RSI is considered overbought when above 70 and oversold when below 30.  The RSI is displayed as an oscillator (a line graph) on a scale of zero to 100.

The basic formula is:

RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

It's a form of time series momentum, so rather than focus on the relative return comparison of securities in the cross-section, time series momentum focuses purely on a security's own past return. In the case of RSI, it's over the last 14 days, so very short term. 

As I've been using it in my own ways for nearly thirty years, and important feature few understand is RSI doesn't always just signal overbought or oversold.

RSI overbought/oversold signals work best in sideways markets, as a price trend is oscillating up and down in overbought oversold cycles. Here's an example of a stock index since 2022. While in a downtrend, the trend is also range bound and contained within a boundary. The RSI is in the lower block with the overbought peaks highlighted in red and oversold lows highlighted green. This is a rough example because the time series includes a downtrend, but you can probably see the value of the relative strength index for countertrend swing trading; buy the dip, sell the rip.

While RSI can be informative in sideways, non-trending market states; it changes to a breakout momentum indicator in trending markets. 

That's what I see now. 

The chart below is a stock index currently. The blue line is the 50 day moving average and the red line is the 200 day, and the black trend line is clearly above them both and the shorter-term 50 SMA crossed above the longer-term 200 SMA, called a Golden Cross, aka an uptrend. 

Now look at the RSI. It's been pushing up over 70 the last four weeks, but it isn't declining to the neutral 50 zone or the 30 oversold signal. 

That's because the stock market has transitioned into a strong uptrend, so the relative strength is a momentum indicator used measure the speed and magnitude of  recent price changes, or what I call velocity.

When there's enough velocity in a trend that it pushes up on the 70-80 level and stays there, it's a bullish signal for the strength of the trend. RSI is confirming the direction of the trend, and some trend following systems use it to signal a material change of trend. 

I've been looking at it for about 25 or so years now, daily, and professionally, and it's confirming strong buying enthusiasm. 

However, I'm still looking for a correction in this uptrend because they don't shoot up forever without a pullback, but the good news is the resiliency of the RSI and market trend increases the probability this reversal to an uptrend may be sustained.  

The bottom line is the U.S. stock market is overbought, yes, but only the cyclical sectors are overbought as of today; Technology, Consumer Cyclicals, and Communications.

I do expect to see a meaningful pullback soon that could last a while, but we would see the non-cyclical defensive sectors like Staples and Utilities sectors play catch up, and keep the uptrend sustained longer than some may expect. 

Just remember, if you use RSI to gauge trend strength and speed, it's not as good of a counter-trend indicator in a sustained uptrend or downtrend. 

Mike Shell is the founder, President, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of Asymmetry® Managed Portfolios.  Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies. Shell Capital provides investment advice and portfolio management to clients with separate accounts at Goldman Sachs Advisor Solutions with an investment management agreement. The observations shared on this website are for general information only and should not be construed as investment advice to buy or sell any security. This information does not suggest in any way that any graph, chart, or formula offered can solely guide an investor as to which securities to buy or sell, or when to buy or sell them. Securities reflected are not intended to represent any client holdings or recommendations made by the firm. In the event any past specific recommendations are referred to inadvertently, a list of all recommendations made by the company within at least the prior one-year period may be furnished upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on the list. Any opinions expressed may change as subsequent conditions change. Please do not make any investment decisions based on such information, as it is not individualized advice and is subject to change without notice. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but are not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. If this website contains information regarding Options Trading, please read the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). Options involve risk and are not suitable for all investors. The views and opinions expressed in Asymmetry® Observations and Asymmetric Investment Returns are those of the authors and do not necessarily reflect the position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.