Using Oscillators for Contrarian Investing

Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”, Don’t Short When it Comes to Secular Investing, An Introduction into Trend Following, An Introduction into Technical Indicators, When does Trend Following Not Work, Risk Management for Trend Followers, Why Trend Following Isn’t that Useful Today, An Introduction to Contrarian Investing

Previously we talked about 3 ways of determining Overbought or Oversold levels (also known as Extremes):

1. Oscillator technical indicators
2. Using Extreme Time
3. Using Extreme Magnitude

In this post we’re going to discuss how to use Oscillators to determine how Overbought or Oversold a Market is. The most common type of Oscillator (a type of technical indicator that uses market price as the sole input to determine Overbought / Oversold) is known as RSI (short form for Relative Strength Index).

Relative Strength Index

RSI is a complex calculation that gives a reading between zero and 100. A reading of 50 is Neutral – it means that the market is neither Overbought nor Oversold. A reading of 100 is Extremely Overbought, which gives contrarian investors a sell signal. A reading of 0 is Extremely Oversold, which gives contrarian investors a signal to buy. Obviously, readings of 100 and 0 are purely theoretical – the market would never get that low or that high.

For those of you who are interested, RSI is calculated like this:

RSI = 100 – 100/(1 + RS)

RS is the (Average of X days up closes) divided by the (Average of X days down closes).

Typically speaking, investors and traders say that a RSI reading of below 30 is considered Oversold, an a RSI reading of above 70 is considered Overbought.

However, these days, the market tends to fluctuate more than it did in the past. Historically, a 2% movement in the stock market would be uncommon. These days, large fluctuations are the norm in the markets. For example, August 2011 saw market fluctuations (in the U.S. stock market) of 5% per day.

Thus, I personally set my RSI Overbought readings at a minimum of 80 and my RSI Oversold readings at a minimum of 20. Any reading that’s too close to 50 (neutral) is useless – you’ll get a lot of useless buy / sell signals.

However, I won’t buy or sell a market just because I get an RSI buy or sell signal. RSI must be combined with other contrarian investing indicators.

What RSI does is that is shows the momentum in a downtrend (bear attack) or an uptrend (bull attack). RSI shows 2 signals:

1. Oversold/Overbought readings.
2. Divergences

A divergence is when the price makes a new high or new low, but the RSI readings don’t make a new high or new low. There are 2 types of divergences:

1. Bullish divergences. This is when the price makes a new low, but the RSI readings don’t make a new low (ie higher than before). This sends bullish signals to investors and traders.
2. Bearish divergences. This is when the price makes a new high, but the RSI readings don’t make a new high (ie lower than before). This sends bearish signals to investors and traders.

What a divergence shows is a weakening of momentum. RSI doesn’t merely show direction (is the trend up or down). It shows the changing of momentum (is it going up or down faster or slower). When a bearish divergence occurs, it means that the market is still going up, but the pace of ascent is slowing down significantly. Thus, the market will soon fall.

Oppositely, when a bullish divergence occurs, it means that the market is still falling, but the pace of descent is slowing down significantly. Thus, the market will soon rally and rise.

There are many other oscillators that are similar to the Relative Strength Index. However, the RSI is the most commonly used type of oscillator among investors and traders. I won’t discuss the other types of oscillators because those oscillators are practically all just derived from RSI. In other words, there’s practically no difference! I’ve tested out the other oscillators, and RSI is by far the most simple and easy to use.