Trading Your Way Through the Perfect Storm

You can use Wilder's Relative Strength Index to navigate emotional extremes in stocks.
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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.

Let's look at

Siebel

(SEBL)

as an example of the use of RSI to pinpoint just when a "perfect storm" is about to run out of momentum.

First Negative Factor

: On Aug. 10, a Goldman Sachs software analyst cut his 2001 and 2002 earnings estimates on Siebel.

Second Negative Factor

: At the open, the

Nasdaq Comp

and the Goldman Sachs Software Index (GSO.X) gapped down. Siebel gapped down $1.59. Nobody wanted to own this stock, and the short-sellers were having a field day. Forget about offering it out; sellers just started hitting the bids, which were rapidly falling away. The stock began selling off sharply.

Third Negative Factor

: The Nasdaq was also weakening, selling off by more than 40 points during the first hour and contributing to the downward momentum of the stock. Siebel eventually dropped almost $2.50 from the open. However, it then turned around and trended up the rest of the day, closing right where it opened. Of course, the easy trade would have been to short the stock at the open, and it was fairly easy to get an uptick due to the extreme volatility in the morning. Nevertheless, Siebel was selling off fast, and those buyers who tried to catch this falling knife either found themselves joining the sellers, or entering a serious House of Pain.

With these three factors, Siebel's perfect storm was raging. Given the extreme emotions so evident in the tape, the best way to trade this event was to be patient and let the selling subside. Then, just hop aboard when the shorts began covering, or when natural buyers thought it was safe to return.

Using RSI to Monitor the Storm's Strength

When making this type of entry, look for 90/10 RSI readings as overbought/oversold indicators -- these reflect absolute emotional extremes. Time periods are also important. There is a fine line between trying to pick the exact bottom vs. spotting a valid reversal of trend. Too short, and you'll often be early and fall victim to the very emotions that you're trying to avoid. Too long, and the emotion is already wrung out of the stock and profit potential is minimal. While many daytraders prefer a five-minute chart, this particular trade has a much higher probability of success if you use a 15-minute time frame. If you do use a five-minute chart, I recommend reducing your RSI period from 14 to a shorter 10-RSI. This shorter time frame makes for a more sensitive indicator, which is consistent with the short-term nature of the trade.I'll focus on the more conservative 15-minute time frame here.

First, a five-minute chart of the Nasdaq for comparison with the price action of Siebel:

Nasdaq Composite -- Intraday
Five-minute candlesticks

Next, look at this 15-minute chart of Siebel, with an RSI of 14:

Siebel -- Intraday
15-minute candlesticks, 14-RSI

The ideal entry is when a bullish three-pattern candlestick formation coincides with an RSI buy signal. Using a 15-minute time frame, this setup takes 45 minutes.

The Entry

    Pattern Bullish Reversal (I call this a "3P-Bull"): RSI Reversing From Extreme Oversold Reading: RSI must have penetrated at less than 10 during the 3P-Bull, and must now be at a higher reading upon complete formation of the pattern. If RSI is not at a higher reading, then pass on the trade. Declining Volume: As the stock continues to trade, volume should decrease, thereby confirming that emotion is waning.

  • The first body shows strong selling pressure (the closing price is much lower than the opening price, exceptionally high volume);
  • The second body shows equilibrium between buyers and sellers (little or no change between the open and closing price); and
  • The third body reveals buying pressure -- closing price is higher than opening price.(Note: I expect to receive unhappy emails from all you picky candlestick traders.)

The Exit

Now that you've entered the trade, you become a risk manager. While you can keep an eye on this 15-minute chart, you might also construct a five-minute chart to monitor short-term movements. Always compare the five- and 15-minute charts for a broader view of the price action. Focusing on a single time frame is like driving with blinders on. Use your peripheral vision! Watch for price reversals on the more sensitive five-minute chart (with 10-period RSI).

Also, because Siebel is a Nasdaq stock, you should follow the Nasdaq Composite Index for an indication of broad market strength/weakness. Here, the Nasdaq formed a rough inverted head-and-shoulders -- an excellent reversal signal -- and then traded higher for the remainder of the day.

Some Final Thoughts

Strict reliance on technical indicators negates emotional trading.

RSI is a gauge of momentum, but you make money on price changes. Therefore, adhere to stops during this kind of trade. As the stock moves higher, raise your stops to lock in profits. Siebel continued to move higher during the rest of the day (the buying was fueled by short-covering and real buyers). A

trailing stop loss would have kept you in this trade for the entire day.

RSI is just one indicator that I find particularly useful for identifying good intraday trades. Do not rely on it exclusively.

I cannot put too much emphasis on scaling. But do it the right way. Do not "average down" just to prolong admitting that you are wrong. There is no shame in taking a loss and waiting for a better entry. That's what money management is all about.

It is always easy to look at a historical chart and pick the perfect entry and exit. What I've tried to do here is highlight common occurrences during rapid selloffs. Always try to find the cause of the selloff. Siebel sold off on a research call by Goldman Sachs. While this research call may prove to be accurate, you shouldn't shy away from trading the stock if your technical indicators give the "all clear" signal.

If you learn to use RSI as your emotional barometer, I'm certain that you'll be able to ride out the "perfect storms" in your future.

Dan Fitzpatrick is a managing partner of Strathmore Capital, a private hedge fund in Englewood Cliffs, N.J. His column focuses on quantitative strategies for investment and trading. At the time of publication, Fitzpatrick held no positions in any stocks mentioned, though positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

fitz92130@yahoo.com.