This very useful indicator could help you beat the market

Do you like the idea of a trading system that doesn’t involving you staring at the markets every day?

One by which you might make five or six trades a year – certainly no more than ten – in a market that you can get in and out of easily?

And one by which you should comfortably be able to beat an index, such as the FTSE or gold?

Then I may have something for you in today’s Money Morning

How to profit from market momentum

Late last week, I had the pleasure of meeting Andrew Craig who runs the website, plainenglishfinance.com. He’s just published his first book, Own The World, about plucking your finances from the expensive hands of fiends, financial advisors, and fund managers, and taking control of them yourself. The first thing he recommends doing on your quest is subscribing to MoneyWeek – so he’s obviously a man of great vision.

We were discussing how it shouldn’t be that hard to make 15% or 20% a year, and how few fund managers or even private investors manage this. By the time you compound that over several years, you’re talking serious money.

Andrew swears he can beat most markets by using a simple tool called the relative strength index – the RSI.

Let me start by explaining how it works. In short, RSI measures momentum. It’s an indicator of whether something is ‘oversold’ or ‘overbought’. When it reaches ‘overbought’ levels, you sell. When it reaches ‘oversold’ levels, you buy.

Andrew uses it in conjunction with other indicators, both technical and fundamental, but for the purposes of today, we’ll use it by itself.

Most chart websites – such as Big Charts or Stockcharts – give you the option of seeing the RSI beneath whatever price you are looking at.

Below we consider the FTSE 100 over the past year.

FTSE 100 chart over the last year

You can see how in May, the RSI went below 30, deeming it oversold. We were in buy-signal territory. Some traders like to use the moment it crosses back through 30 as the actual buy signal. At this point, the FTSE 100 was at around 5,250.

Now that the RSI has gone above 70, it is ‘overbought’. This suggests that you should be thinking about taking profits – or at least sticking in a very tight stop to protect them, if you think the market has further to run. The moment it crosses back down through 70 is the moment many traders use as their sell signal.

Let’s assume that we have a sell signal now, for the sake of argument. At 6,180, you’ve made over 900 points.

With just one trade last year, it involved low commission costs. You didn’t have to spend all your time looking at screens – you could have got on with that important skiing holiday. You got in close to the low for the year and you made about 18%. Nice work!

Why you shouldn’t rely on just one indicator

Of course, this is just one example where the method happens to have worked well. Back-testing it, there are plenty of examples where it hasn’t.

For example, in a bull market, you tend to get a lot of overbought readings – sell signals – and very few, if any oversold readings – buy signals. You sell, the market carries on its rapid ascent and you miss out. Very frustrating.

(In fact, judging by readers’ emails, investors find missing out on a run even more frustrating than being trapped in a bear market.)

The same applies in a severe bear market. In 2008, for example, there were a lot of oversold readings – which might have made you buy – only for the market to head a lot lower.

This is why RSI tends to work best when used in conjunction with something else. This might be some fundamental analysis you have done or read on a market. Perhaps the economics and financials are such that you really feel you should own a certain asset, and just want to find the best time to get in.

Or it might be another technical tool, such as moving averages, (which I like). Or it might be a tip from somebody, another trader or a newsletter writer, who you follow.

Here’s a good example of why you need to be careful about relying on just one indicator. The chart below shows silver in 2010-11 – when it made that huge run from $15 to $50.

Silver price chart 2010-2011

The RSI gave a lovely buy signal at $15 in February 2010. The following October it gave a sell signal at around $23. That made you $8 in as many months.

Very nice trade. Open the champagne.

Then look on in horror as, without giving another buy signal, silver launches all the way to $50 without ever seeing $23 again. (Something similar happened to me, you may remember, as I wrote about taking some profits at, I think, $30.)

That’s why I advise using this indicator in conjunction with something else. Andrew, for example, says he held on when he got his first sell signal on silver because the volumes were so strong. Volume is pretty telling as far as interest in a market is concerned.

Another way to use this indicator – if you have the facility on your charting software – is to change the parameters of RSI. (Stockcharts offers this facility.) I have used website’s default settings above (that’s the 14 day RSI). Playing about, I have found that a ten-day RSI works well for a gold, although it gives you a lot more than one or two trading signals a year.

Currently the major indices – the Dow, the S&P, as well as the FTSE – are all approaching overbought levels. Gold and silver both issued buy signals in late December, having given sell signals back in December.

I’ve decided I like RSI and will use it a lot more in future to help me with my market timing. If you want to find out more about Andrew’s book, Own The World, and his work, visit www.PlainEnglishFinance.com.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

Our recommended articles for today

Why this oil legend isn’t retiring yet

New technology has enabled undersea coal fields to be tapped for gas. And as one veteran of the industry knows, it’s only a matter of time before Britain profits. Tom Bulford reports.

Here’s why we must raise the minimum wage

When the taxpayer is forced to step in to support a worker’s basic standard of living, something is seriously wrong. Raising the minimum wage is the only realistic solution.

12 Responses

  1. 23/01/2013, Fittster wrote

    If this works why is Andrew, telling the world about? The fact that Andrew isn’t in the Buffett league suggests that he approach isn’t that great.

  2. 23/01/2013, David wrote

    RSI AND stochastics are only meant to be used when a market is trading within a range . Moving averages should be used in trending markets. You need to determine whether the market is trending or in a range first before you use the correct indicator. It is why moving averages
    ceased to be useful in the gold market.

  3. 23/01/2013, david wrote

    Do you really think Warren Buffet uses technical indicators?

    • 16/06/2013, Bo Stenberg wrote

      At this point, Buffett dictates the terms of the buy simply because he is Buffett. To this extent, he is more remote from “market timing” than you and I. At the beginning of his career back in the 50’s, he was working according to the value investment rules as laid down by Graham and Dodd–looking to buy cheap. However, his well-known maxim of buying when they’re scared and selling when they”re greedy clearly implies market timing. RSI tends to conflate with fear and greed. It is more closely allied to behaviorist principles than it appears.

  4. 23/01/2013, Steve wrote

    Great interview with Andrew. Backs up what I have ben mulling over for some time. Thanks

  5. 23/01/2013, Colin Selig-Smith wrote

    These are trading, not investing tools. Handy for choosing the moment to buy or sell when you’ve already made the decision using other tools.

  6. 24/01/2013, Roger wrote

    had a quick check with SP500, no, it does not work for extended periods, if you insist using the rule, you will be loser for extensive periods. Of course, if you add personal judgement at the time, it maybe OK, but mathematically it does not work

  7. 24/01/2013, Andrew Craig wrote

    I thank Dominic very much for this article but would like to clarify (and I hope I don’t cause any offence here Mr. Frisby) that the statement “Andrew swears he can beat most markets…” isn’t quite a fair representation of my thoughts on the matter (unless I had a rush of blood to the head and was more effusive than I meant to be!).
    I would never claim to be able to consistently “beat most markets” but I would stand by the fact that RSI has been a superb tool for timing entry and exit investing in the precious metals in particular for several years.

  8. 24/01/2013, Peter wrote

    Could you tell us how the RSI is calculated? From memory and summarised it it the ratio of up candles to down candles in the last 14 days. So if the market goes up so does the RSI. It is only telling you what you can already see in the candles. Have you any stats on how much better using RSI is than the 50/50 chance you have guessing the right direction?

  9. 24/01/2013, NVP wrote

    hey all

    using the RSI as a lead indicator ?

    c’mon dont insult the many traders that read moneyweek

    NVP

  10. 24/01/2013, Adrian wrote

    An article, or series, on tech analysis would be welcome in the mag. I’m low on the learning curve, and would only trade with a small proportion of my portfolio, but does taking weekly or monthly figures reduce the blips talked about in the piece?

  11. 04/03/2013, Jerry wrote

    First of all no offense but RSI is “NOT” an overbought/oversold indicator. The developer of the RSI J. Welles Wilder no where in the chapter on RSI, did Wilder ever write that the RSI is an overbought/oversold indicator. Nowhere in his book did he write that RSI below 30 is oversold (therefore buy) and RSI above 70 is overbought (therefore sell). Nowhere is this ever mentioned in his book.

    He says RSI is a “momentum oscillator” which measures the velocity or directional price movement. When the price moves up rapidly, at some point it is considered to be overbought; when it moves down very rapidly, at some point it is considered to be oversold. In either case, a reaction or reversal is imminent.

    So in short, RSI only gives the “indication” NOT the “confirmation”, that is why divergence is used in trade.

Commenting on this article closed

MoneyWeek magazine

Latest issue:

Magazine cover
Heading higher?

Or are house prices set to fall?

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 4 FREE Issues

'Would you rather upset God, or have Him just ignore you?'

In the first of three interviews with Merryn Somerset Webb, Hugh Hendry, manager of the Eclectica Fund, talks about what it takes to be a good hedge fund manager – and how he learned to stop worrying and love central banks.


Which investment platform?

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from. They all offer various fee structures to suit individual investing habits.
Find out which one is best for you.


26 November 1703: Britain hit by the original 'Great Storm'

Town and country were left devastated, hundreds of ships were lost and thousands died when the worst storm in the history of Britain reached its peak on this day in 1703.