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Stochastics (SI) and Relative Strength Indicator (RSI)

Dr. George Lane popularized the stochastic indicator (SI). RSI is essentially similar to the SI. The difference is that SI has two values, while RSI has only one. The second SI value is derived by computing a moving average of the first SI value. Both indicators are often used to indicate theoretically "overbought" or "oversold" conditions. They may both be used as timing indicators as well as indicators of so-called "overbought" and "oversold" conditions.

The Good News. Both the RSI and SI have considerable sex appeal. By this I mean they look good on a chart. They tend to identify tops and bottoms quite well.

They are also useful in timing, provided one uses the appropriate crossover areas for timing trades. See Figures 2-2 and 2-3 for examples of SI and RSI, respectively.

The Bad News. The concepts of overbought and oversold are not useful, and they can get you into trouble. Both indicators tend to continue in what is called "overbought" territory or "oversold" territory for a long time. As prices move higher and higher, the indicator remains "overbought," and vice versa. The problem is that traders often equate the term overbought with a market top and oversold with a market bottom. This is not always true. Many times a market will push higher and higher while traders continue to fight the trend based on an overbought RSI or SI reading. The same will hold true in downtrends.

Solutions. Don't use the SI and RSI for determining overbought or oversold conditions. Use these indicators as timing methods when the readings cross above or below certain values. You might also consider using RSI and SI with other timing indicators.

Finally, I have developed my SI "POP" method that may be helpful in trading moves that occur in overbought and oversold territory (see my book Short-Term Trading in Futures). Another method of using the RSI and SI is to exit trades using a shorter indicator length than was used for entry.

Figure 2-3. 9-period RSI on 10-minute T-bond futures showing buy (B) and sell (S) signals. Note that one method of using RSI is to buy on RSI values above 50 and to sell on RSI values below 50.

Chart Patterns and Formations

These methods are based on the traditional analyses as proposed by Edwards and McGee, as well as other methods such as those developed by W.D. Gann, George Bayer, and R.N. Elliott. There are many different chart formations and various outcomes possible for each. They require a good deal of study and are, at times, quite intricate. I have included only one example of these, since the literature is loaded with methods and systems based on these approaches. (See Fig. 2-4.)

The Good News. These methods are highly visual. In other words, you can draw lines on a piece of paper and see what should be done. In addition, the methods don't necessarily require a computer, and they can be learned by almost anyone. Frequently the prescribed actions are specific, once you have completed the necessary interpretation of the chart patterns. The methods are usually quite logical. Hence, they have a good deal of face validity.

The Bad News. In most cases, these methods are highly subjective and difficult to test for accuracy. The Gann and Elliott methods, for example, have been known and used by traders for many years; however, there is considerable disagreement, even among experts, as to what patterns exist at any given point in time and, in fact, how these patterns should be traded.

Solutions. A possible solution would be to use the methods in conjunction with other timing that is more objective and operational.