The Tycoon Report

Timing the Opportunity that Most Will Miss

Thursday, July 16, 2009 | Bob De Dea

Happy Thursday to you all. Just to let you know, next Thursday I’ll be taking my first week off
since I started writing for The Tycoon Report in November, as it's my birthday. On top of that,
the show I’m directing, "SOUVENIR: A Fantasia on the Life of Florence Foster Jenkins," is opening
next Friday night and I’ve got to get busy buying opening-night gifts!    

Last week, in a very informative article, Chris Rowe wrote about the Relative Strength Index (RSI). Today, we’re going to look at one of my favorite indicators, which I’ve been putting to the test over the last few months, the StochRSI.

Once a trend has been identified, this indicator is great for timing entrances and exits in the short term.

As Chris mentioned, the RSI is a momentum indicator that compares gains to losses over a period of time. Stochastics, as students of the "ETF Master Trader" program well know, provide a momentum oscillator that compares a security’s closing price to the high/low range over a specified period of time.

The thing about the RSI is it often doesn’t go to extremes -- instead, it will remain between the oversold and overbought levels (that is, between 20 and 80). If, for example, you want an entry into the trend and are looking for a price extreme, it’s possible that the RSI won’t give you one. That’s where StochRSI comes in.

The StochRSI is a crossbred creation of Tushard Chande and Stanley Kroll. RSI acts as the base and the stochastic calculation is applied to it.

The formula is mind-numbing, so I won’t show you its details. Suffice it to say that the resultant number fluctuates between 0 and 1 and gives us an oscillator that measures the level of RSI relative to its recent high/low range, thereby providing short-term momentum extremes.

As Chande and Kroll point out in their book, "The New Technical Trader," “The StochRSI is a more consistent indicator of overbought and oversold conditions simply because we are measuring its position within the most recent range.”

The group of charts below shows a security chart with RSI, Full Stochastics and StochRSI beneath.



Uptrends and Downtrends -- What the Levels Mean

At the end of 2006 and well into 2007, United States Steel (X) had a steady rise. The green lines show opportunities to buy into this uptrend when the StochRSI line crosses from below the 0.20 to above it.

Just like in the RSI or the BPI, which have overbought and oversold ranges (above 70 and below 30, respectively), the StochRSI is considered overbought above 0.8 and oversold below 0.2. (A 0.2 StochRSI reading actually means that the current RSI is 20% above the lowest level of the time range measured, or 80% below the highest level or the RSI for the period.)

So, during the steep descent of U.S. Steel starting in mid-2008, the red lines show opportunities to:
After spending some time studying this indicator in conjunction with bunches o’ charts and figuring out how best to use it, I’ve discovered that the most-dependable signals are given when the move goes straight from overbought to oversold or vice versa.

But I circled the StochRSI in October-November 2007 (in blue) to point out that sometimes the signal fails when it returns quickly from overbought to oversold (the late-October quick jump). It didn’t really break out until mid-November.

This is why this indicator works best when used in conjunction with other longer-term indicators. (I’ve found the Moving Average Convergence/Divergence and the StochRSI are a dynamic duo.)

Also, in an uptrend, the reverse moves downward usually constitute a brief consolidation as opposed to signaling the time to exit a position. This does not mean, however, that you should not have a stop-loss in place. Always use stop-losses!

Likewise, in a downtrend a move upward should be noted but not necessarily acted upon. This can vary from security to security and may or may not depend on the severity of the move, so be sure to study the StochRSI in conjunction with the long-term (historical) tendencies of the security.

Another way to use the signal is similar to the plain-vanilla RSI, where you watch for centerline crossovers. A move above the StochRSI centerline (0.5) would constitute a buy signal that remains in effect until a decline below 0.5. Conversely, a drop below 0.5 would signal a sell until an advance back above 0.5. Although this can have you in and out of the market more than you might like, it can also help eliminate whipsaws.

Positive and Negative Divergences can also be plotted using StochRSI, although I personally like to use MACD histogram divergences.

Here’s a closer look at recent activity for a chemical company, Omnova Solutions Inc. (OMN):


 
The first red line at left marks the December downtrend. As we all know, the market was a bit wacky through the first couple of months this year, then started rallying. I’ve marked the recent moves below 0.8 on the StochRSI as red vertical lines and the points where I bought into the stock -- where the StochRSI moved above 0.2 -- as blue vertical lines.

Now here’s a perfect example of a consolidation in an uptrend. I could have sold off my position at each dip below 0.8 and bought in again at the next move above 0.2, but my stop-losses were never activated. (With stocks under $5, I use a fixed-amount stop-loss.)

The green boxes show that the stock never really turned down, just took a breather. After the second occurrence in April, I knew that this particular security was likely to follow this pattern again, as it confirmed in May-June.

The bottom line is that I more than doubled my money, buying into four positions when the StochRSI moved above 0.2.

(Some of you eagle-eyed traders may ask why I didn’t buy in on April 13 or May 13 or May 26 or June 1. The answer for the first three dates is that the move happened too soon after the drop and I suspected a false signal. On the first June crossover, I wasn’t actively monitoring my position as I had had oral surgery and was in la-la land.)

To Recap

When RSI registers a brand-new low, StochRSI will be at 0. When RSI registers a brand-new high, StochRSI will be at 1.

Remember that StochRSI is really an indicator of an indicator. We’re using it to track the price change of a security, but it’s designed to track RSI.

As such, it is one step further removed from the actual price of the security it tracks. And it serves to predict RSI, which means it’s more sensitive and therefore more prone to false signals.

So, know the security you’re tracking, know the market and industry conditions, and know the trend. And use other longer-term indicators to make sure you’re on the right side of the action.

Once you’ve done all that, StochRSI will give you an advantage over the rest of the crowd, getting you into or out of a trade early, instead of too late.





Bob De Dea
Guest Contributor
The Tycoon Report