Technical Analysis v Fundamental Analysis
Measures below 20 and over 80 are very rare and can signify the final throes of a trend particularly when the trend is long in the tooth. A simple way that I find to understand this indicator and what it is telling me is as follows: assuming a 14 period RSI, a zero RSI value means prices moved lower throughout the entire 14 day period, i.e. there were no gains to measure. An RSI of 100 results when the average loss during this period equals zero, i.e. the price moved higher throughout the entire 14 day period; there were no losses to measure. When a divergence occurs between the RSI measure and the underlying price action, this is usually a strong indication that a market turning point is imminent. Bearish divergence occurs when price makes a new high yet the RSI makes a lower high and so failing to confirm the price action. Bullish divergence occurs when the price makes a new low but the RSI makes a higher low.
We will look at a real live example with the Spanish market. You will see that here we have a bullish divergence - I have put a square around the RSI measure to the top (14 day RSI used). Although prices have continued to grind lower (at time of press), the RSI is beginning to rise, i.e. on a daily closing basis, prices are actually gaining strength relative to the 14 day closing average. What you generally see at a true bottom is the RSI makes another low over the period in question, but the underlying instrument rallies sharply on a particular day or successive days. This will still leave the RSI in oversold territory, but the price action tells you that the bottom is in place. As the RSI is a ‘smoothed’ measure of a particular period, then it will, by its very nature, ‘lag’ the underlying instrument price — this is an important consideration. Regular readers of our blog will know that I believe the Ibex (Spanish) market to: (a) fundamentally be materially undervalued, and (b) to be probing out a technical bottom. It will be interesting (not least to my P&L!) to see how this plays out over the ensuing weeks and months.
June 2012 | www.financial-spread-betting.com | 19