Trading Your Way Through the Perfect Storm

Editor's note: This is Dan Fitzpatrick's second column addressing quantitative strategies for trading and investing (click here to read his first article). Fitzpatrick's first four columns will be published to both TheStreet.com and RealMoney.com; the latter is our premium site for subscribers. After that, his columns will only appear on RealMoney.com. Enjoy the article, and, as always, tell us what you think!

I recently got around to watching The Perfect Storm, and I couldn't help but compare it to some experiences I've had trading. Three storms collide to create one apocalyptic event: one boat with too little information, heading right into the center of a hurricane. Ugly! Perfect storms sometimes occur during the trading day: A fundamental news event combines with a weak market and weak hands holding a stock. Concern turns to fear, and fear turns to panic. But if you have the luxury of standing on the sidelines, you can use Wilder's Relative Strength Index, or RSI, as a barometer for measuring the strength of emotion behind a rapid selloff, and then go long when most of the storm's strength has dissipated.

In my last article, I discussed the use of RSI for gauging the strength of a trend by looking for divergences. Here, I'm focusing on RSI as an "emotion indicator" -- an indicator of the emotional intensity of those already trading a stock. Aside from early morning and late afternoon action, stocks tend to trade in relatively small ranges, and RSI spends much of its time in the middle of the range as market makers simply trade for the spread. Only occasionally will RSI give an extreme reading, and that is usually in response to some fundamental news event.

In these skittish times, negative news often causes a stock's movement to develop a life of its own: Emotions are running high, and traders are willing to sell (or buy) the stock at any price, resulting in dramatic price movements. The RSI reaches an extreme reading, signaling an extremely strong trend. But at some point, traders become exhausted. Those who wanted in are already in, and there is no more "new blood" to push the stock up. At this point, reversal is imminent. ...