Is the Trend Really Your Friend? Ask RSI

Editor's note: With this column, we introduce Dan Fitzpatrick, a managing partner of Strathmore Capital, a private hedge fund in Englewood Cliffs, N.J. His column will focus on quantitative strategies for investment and trading. As always, give us your thoughts.

The market ain't what it used to be. The only obvious trend is that there is no trend. I look at hundreds of charts each day, searching for tradeable trends in indices, sectors or individual stocks. But what seems oversold one day is overbought two days later. You can feel the lack of conviction in the daily price action. Even when you do happen to spot a trend, how can you be certain that the trend won't stop on a dime just after you've committed to the trade?

One indicator you should check is Wilder's Relative Strength Index, or RSI. RSI measures a stock's strength relative to itself, by comparing the most recent price action with prior price action for the same stock. By comparing the RSI trend with the stock's trend, you can spot divergences that signal when the stock's trend is about to change.

One of the biggest advantages of RSI is its ability to filter out the noise caused by volatility and, instead, produce a smooth signal. RSI compares the total price gains for periods when the stock closed higher against total price declines for periods when the stock closed lower. The RSI signal is smooth because it averages these figures over a specific period of time -- in this case, 14 days. (For a detailed explanation of the RSI formula, refer to Technical Analysis of the Financial Markets, by John J. Murphy.)

RSI for Trend Strength Assessment

Keep in mind that RSI oscillates between 0 and 100. Most technicians interpret an RSI reading below 30 as signaling an oversold condition, while RSI readings above 70 indicate an overbought condition. If the stock is posting large gains with only minor pullbacks, then the RSI will be moving toward 100. If the stock is rapidly selling off with only minor rallies, the RSI will be moving toward zero.

To analyze trends, you simply compare the trend of the stock against the trend of the RSI. You will often see prices continue to trend higher, even though RSI has already peaked around 70 or higher and has moved lower. The price continues to rise, but at a slower pace. This slower pace suggests that the trend is running out of steam. It is this divergence on which most technicians focus, looking for situations where the RSI has reversed trend while the price trend -- for the moment -- remains intact. As such, RSI is an excellent leading indicator for future price action. It provides an early warning signal that the trend is weakening and ripe for reversal.

Let's look at a daily chart for Procter & Gamble(PG Quote) . We'll look at these elements:

1. The early warning of P&G's price decline in late February;
2. The reversal of the downtrend in late April;
3. The current uptrend.

Click here to view the Procter & Gamble chart I discuss below.

February Warning Signs: During the first two weeks of February, P&G was moving up strongly, but was still range-bound. Over the past few months, whenever RSI peaked at or above 70, Procter & Gamble sold off shortly thereafter. On Feb. 16, RSI peaked at 83. Two days later, RSI had dropped to 76, while P&G was almost two points higher. Note the divergence here. P&G was trading higher, but RSI was not confirming the new highs. Based on prior behavior of the stock, this was your cue to close out any long positions. For short-sellers, this was also a great signal to open a short position. Notice that even though RSI had peaked, the 10-day moving average was still trending higher. (This is common because moving averages lag, while RSI leads.)

Procter & Gamble then closed below the 10-day moving average and trended down for the next two months. RSI signaled a prolonged oversold condition during much of this descent. If you shorted this stock into the pullback, a good exit strategy was to either set a trailing stop loss, or wait until the 10-day moving average reversed.

April Trend Reversal: During the last week of April, P&G was still trending lower while RSI began making higher lows. This divergence was the first signal that the price downtrend was weakening. That was definitely time to close any short positions. The confirming signal that all shorts should be covered occurred on April 27, when Procter & Gamble closed at $59.83 (the high of the day), and the 10-day moving average was moving up. Let's fast-forward to what's happening with P&G now.

Recent Uptrend:

Mid-May: Once again, RSI peaks and Procter & Gamble begins selling off.

Early June: P&G moves higher and RSI bounces off 30. However, notice that P&G repeatedly gaps higher, but closes lower. This is not the sign of a strong stock.

June 18: P&G made a new recent low, but RSI made a slightly higher low. This price/RSI divergence was your first buy signal. While this looked promising, Procter & Gamble was still in a downtrend (beneath its 10-day moving average). Only when P&G broke above the trend line was it safe to buy this stock.

Early July: During the first week of July, P&G broke above the trend line. It is time to buy its shares. A key point: It is OK to buy a stock when RSI is overbought if you have other technical reasons for doing so. Here, P&G breaks the trend line on increasing volume. Just take the stock and set a trailing stop.

Late July: During the last half of July, RSI and price once again start diverging. While P&G is in an uptrending channel, RSI is trending lower.

Currently: Currently: Procter & Gamble recently broke through the top of its channel And RSI, while still overbought, is confirming the uptrend. This is not an ideal entry. Over the past week or so (not shown on the chart), Procter & Gamble has fallen back into the channel and appears to be consolidating. Keep an eye on volume as another confirming indicator. If Procter & Gamble continues to trade higher in the days ahead on declining volume, there is a strong likelihood that the rise will be short-lived, and PG will continue to consolidate. Any new long positions should be protected by a trailing stop. I would love this stock to fall back to about $72 before entering, but I'm not holding my breath.

Bottom line: P&G is at a crossroads right now. I'm not into forecasting, so I can't say whether Procter & Gamble will break to a new 52-week high or will pull back. But that's the beauty of setting stops to protect profits. If P&G continues higher, just keep raising your stop-loss level. If it pulls back to a better entry, take the stock. Procter & Gamble is definitely not a short at this point. While all prior RSI peaks were followed by a steep selloff, the July peak was different. RSI just meandered slightly lower, before it began confirming P&G's current uptrend.

I hope this gives you some ideas for using RSI to assess the strength of a trend and to make better trading entries. I think you'll find it a very reliable indicator for determining whether the trend is really your friend. Come back for my next article, where I explain how RSI can be used to trade emotional extremes for very short-term traders.