Technical Stock-Picking: Strength Trading With the 'RSI'

This technical analysis-based assignment was written by Stockpickr member Ira Krakow.

For technicians , the price chart is pretty much the most important thing in their stock market toolbox. In fact, one could argue that price movement is the only thing that matters.

It would be wonderful if we could all just buy the stock that's moving up the fastest, in the hope that it will continue to move up and gain instant profits. Unfortunately, in too many instances, the stock price starts to move down as soon as you buy it -- a situation that a technician might call a "head fake."

For this reason, technicians use a variety of supplemental chart indicators to test whether the upward (or downward) price movement is "real."

In addition to the moving average, Bollinger Bands, and stochastic oscillators, another frequently used indicator is the Relative Strength Index, or RSI.

Are Gold Prices Strongly Trending Higher or Lower?

As with the stochastic oscillators, the RSI calculation considers a statistic -- for the RSI, it's the stock's closing price over a period of time -- and transforms the statistic into a percentage (from 0% to 100%), which measures the strength of the price trend, from weakest to strongest.

Below is a daily chart for streetTRACKS Gold Shares GLD exchange-traded fund (ETF) for the year between March 28, 2007 and March 27, 2008, with the RSI plotted below the price.

To learn how to create one of these charts on your own, check out the step-by-step appendix at the end of this assignment.

Click here for larger image.

The RSI can be interpreted in two ways. One way: When the RSI crosses the 80% (some technicians use 70%) line, many technicians consider the stock to be overbought , and a candidate for a "pullback." Conversely, when the RSI crosses below the 20% line (some technicians use 30%), the stock is considered oversold and a candidate for a "bounce" upward.

Another way: When the RSI crosses from below 50% to above 50% on a bullish chart, the move is considered to be getting stronger and when it crosses from above 50% to below 50% on a bearish chart, the move is considered to be getting weaker.

In either case, using the chart above, many signals are generated. However, a good number of them are head fakes. You need to fine-tune your analysis to separate out the valid signal from the noise.

The RSI formula uses the difference between the current day's closing price and the previous day's closing price for the last 14 trading days (the most commonly used number). If the stock closes higher on bigger moves more often than it closes lower on smaller moves over that time period, then it's in a strong uptrend.

On the other hand, if the stock continues to close lower than its previous close, then it's in a strong downtrend.

Do Gold Mining Stocks Follow the Price Of Gold?

The gold ETF is designed to trade at roughly 10% of the spot price of gold. So when the price of gold is $900, the gold ETF is supposed to trade at $90. However, because of the nuances of ETFs, this tracking is not always exact. Still, it's fairly close.

Now is buying the gold ETF the best way to profit from gold price moves or would one or two gold mining stocks be a better play?

Your RSI Assignment

To put the RSI to work, find the best trades to take advantage of gold price moves.

Step 1. On Stockpickr, create a portfolio called "Gold Analysis With RSI: [Your Stockpickr Username]." (To create a portfolio on Stockpickr, you'll need to first log-in. If you're currently not a Stockpickr member, you can register at www.stockpickr.com/register.)

Step 2. In addition to streetTRACKS Gold ETF, add the following gold mining stocks: Yamana Gold AUY, AngloGold Ashanti AU, Goldcorp GG, Kinross Gold KGC, Barrick Gold ABX and Newmont Mining NEM.

Step 3. Using Yahoo! Finance's Charts, plot a one-year daily line chart, with the RSI, for each gold mining stock. Document the day and price that the RSI produced an overbought or oversold signal in the "Reason?" box for each stock.

Does the price action in the gold mining stocks mirror the price action in the gold ETF? Why or why not? If not, perhaps this merits further fundamentals research on the individual gold miners by looking at whether or not they can actually make a profit from their gold mines.

Step 4. Pick the three stocks that you think are the best trades. For each stock, plot an intraday chart with the RSI indicator below it. Use either of the two ways (described above) to generate a signal.

When the RSI gives a buy (or oversold) signal, note a simulated Buy order and make sure to record the date and time in the "Reason?" box. When the RSI gives a sell (or overbought) signal, note a simulated Sell order. Again, record the date and time in the "Reason?" box. How many times did you trade? Were you able to make a profit?

Step 5. Perhaps one day is too small of a window. If so, follow these three stocks each day for the next three trading days, using the RSI to time your buys and sells.

Were you able to make a profit this time?

The RSI can produce some pretty nasty head fakes. So please use it with caution and only in combination with price, volume and other technical indicators.

Comparing the signals on daily, weekly, monthly and one-year time frames, will probably produce different signals. That said, as always, before you risk serious capital , you definitely need to first experiment with a "virtual" account, until you gain enough knowledge and confidence to trade with real money.

Appendix: How to Generate the RSI Graph With Yahoo! Finance Charts

Follow these steps:

1. On the standard quote page, click "Basic Tech. Analysis" on the left side of the screen.

2. In the "Indicators" section, click "RSI."

Ready to put your stock-picking skills to the test? Check out TheStreet.com's Beat the Street at beat.thestreet.com.