V.11:8 (346-350): Pattern Recognition, Price And The RSI by John Knaggs

Pattern Recognition, Price And The RSI by John Knaggs

Here's how to combine price and relative strength index patterns for trading signals.

Patterns can be found between price formations and such mathematical trading tools as the relative strength index, the momentum oscillator developed by J. Welles Wilder Jr. Such price and indicator patterns, together with their variations, tend to repeat, allowing traders familiar with them to gauge the maturity of a given buy side or sell side price trend and thus recognize when the trend is peaking. This knowledge can help a trader stay with a price trend until the trend has run its course. It can then aid in generating a trading signal to either exit an established position or initiate a new one.

The relative strength index (RSI) plotted along with price is used to ascertain overbought/oversold and divergent situations. Price declines have many different forms, each with their own characteristic RSI pattern. The RSI as used here is calculated on a 14-day cycle, an interval I find to be most useful when the price trend is changing. The trading signal we will be watching for is characterized by these elements:

1 A downtrend in prices characterized by lower lows.

2 An uptrend in the RSI (divergence), which in turn creates a gradually rising support zone. The RSI probes this zone as prices make new lows.

3 Some buy side activity in price behavior that precedes our trading signal but does little more than run price to the upper region of its down channel. This results in an upward spike in the RSI, which helps us see the potential end of the price decline. We'll use this spike to help determine the timing for a potential trend-reversing trade.

4 The first consolidation of prices after they accelerate into the new trend.

Figure 1 is a chart of December 1987 Treasury bonds for the period September 8 through October 19. Compare the price trend to the shallow, angled trendline drawn under the RSI for the same period. Note the price and RSI diverge. On October 13 the RSI spikes upward, with buy side prices well within the downside price channel. As the RSI gradually settles into its own rising support level, prices begin to fall to new lows.

Studying price alone in this example as it makes new lows gives you little or no clue to the fact that prices have gathered support and are ready to reverse direction. A study of the RSI, however, shows that each successive marginal new low in closing price for the four days leading up to October 19 draws the RSI down closer to its own rising support level. This pattern hints that price support is accumulating and we can interpret it as a trading signal.