This article will be the first of several in an attempt to clearly define some of the more common technical indicators we use in our own portfolio management practice and how we apply them. We are going to start our journey with the Relative Strength Index (RSI).
The original article by Lance Roberts has been edited here for length (…) and clarity ([ ]) by munKNEE.com to provide a fast & easy read.
Exactly what is RSI and how is it calculated?
…It is a “price” momentum indicator that measures the magnitude of recent gains and losses over a specified period of time. It is essentially a measurement of the “speed” of price gains, or losses…RSI is a “tool” that can be used to help identify better entry or exit points for investor capital.
The RSI is calculated using the following formula:
RSI = 100 – 100 / (1 + RS) where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time-frame
RSI values range from 0 to 100…
- An RSI value of 70 or above indicate that a security is becoming overbought or overvalued, and therefore may be primed for a trend reversal or corrective pullback in price.
- An RSI reading of 30 or below is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.
There Is Not Just One
There is no indicator that is an “absolute.” Since markets are driven largely by emotion, large price movements can create “false” buy or sell signals in the RSI, or any “price” based indicator.
One can’t simply use a single metric to manage risk in their retirement portfolio. It takes a suite of indicators, observing them all in unison, and making buy and sell decisions based on the weight of the evidence at hand and this is why all indicators perform the best when:
- Used in conjunction with other, confirming technical indicators,
- Periods and duration are matched to investment horizons,
- Combined with the overall investment discipline (buy/sell strategy), and;
- Utilizes the K.I.S.S. principle (Keep It Simple, Stupid)
The two biggest problems, in my opinion, that investors run into when trying to implement technical analysis into their portfolio management are:
- They try and use too many different indicators which create contradicting signals which leads to investment “paralysis.” Keep it simple.
- A lack of a “buy” and “sell” discipline which corresponds to the technical signals being given. Any portfolio management process is only as good as the investor discipline to adhere to it.
Currently, the RSI index is registering a level that has only been seen a few times previously throughout history (the market is currently more overheated today than it has been in more than 67 years). However, given the longer-term time frames of the indicators we use, these “warning” signals can take some time to “play out” within the markets…
We are most likely headed for a 5-10% correction sometime this year which would be “healthy” for the markets and provide a “buying” opportunity for the time being. The problem is that it has been so long since investors have even seen a 2-3% correction, a correction of 5%, or more, will “feel” much worse than it actually is which will lead to “emotionally driven” mistakes.
Technical analysis is a method to extract “emotion” from the “buy/sell” process. The fundamentals dictate WHAT we “buy” and “sell” in portfolios, but it is the technicals that drive the WHEN those decisions are implemented.
Related Articles From the munKNEE Vault:
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Remember, the trend is your friend and now you have an arsenal of such indicators to make an extensive and in-depth assessment of whether you should be buying or selling. If ever there was a “cut and save” investment advisory this article is it.
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The Web is crawling with technical analysis (TA)…[and,] given its popularity, [begs the questions as to whether or not there] really is something to it. [Based on our research,] the short answer is no, not really, at least not in developed markets like the US or the UK… Furthermore, most of the popular TA indicators that are bandied around are nonsense jargon and should be ignored as useless noise. [Let us explain our position.]
Research has found that investors using technical analysis had some performance advantage over those who didn’t use these methods. The research also found that the performance advantage was more evident during down markets. If that has piqued your interest, read on to learn more about a few of the more popular types of technical analysis.