Relative Strength Index (RSI): BAMM Theory

RSI BAMM

As the bear markets of 2000 and 2008 demonstrated, the need for strategies that determine the overall bias is essential to develop a relative perspective on the position of any trade. For example, there is a significant difference between a long position, representing a continuation of the predominant bullish trend, as opposed to a brief correction within the overall downtrend. Despite the prevalence of distinct patterns that favor one side of the market or the other, the larger time frame and predominant trend will always dictate the extent of any move and the possibility for profit.

TECHNICAL INDICATORS

Larger trend considerations such as these were not the only new factors that helped determine the overall bias during these challenging bear markets. Other technical measures such as Relative Strength helped to confirm the extent of the predominant trend. Furthermore, these considerations have become increasingly more vital to the Harmonic Trading approach and in the determination of the overall validity of patterns as reliable structural signals.

Although indicators were not new to my analysis, as I frequently employed these studies and others such as Volume and Price Gap strategies, I must admit that I was not always as open- minded regarding their importance. When I initially started to define the Harmonic Trading approach, I employed simple trend lines, Volume, and a few other technical studies to complement my existing price pattern analysis. The main focus of this approach was always on the completion of price patterns. As I examined other complementary strategies to filter the pattern completions, I realized that indicators and oscillators provided significant technical signals that helped gauge the overall state of the price action.

Actually, I first discussed the dynamics of harmonic price action as it relates to the Trend, Volume, and Price Gap studies in The Harmonic Trader. In this book, I outlined trading strategies that analyzed patterns within the context of well-established trend channels, as well. In recent years, I investigated a variety of technical indicators, including Stochastics, Volatility Bands, MACD, and Relative Strength. Of all these measures, I have been looking for the technical measure that would reveal the extent of buying and selling relative to the predominant trend. Since price patterns often represent the structural end of a significant trend, it seems that it is most important to understand some type of relative measure that manifests the degree of buying and selling at critical harmonic areas. Although many technical indicators were advantageous in my research, within the framework of this approach, certain measures offered more relevant and reliable predictive information. From a harmonic pattern perspective, the structure is as important as where it completes relative to its prior price history. Therefore, the importance of the relative structural alignment led me to the Relative Strength Index (RSI), which provided that measure.

The integration of other technical studies, in particular RSI, was a significant evolution in my research. As a dedicated student of the financial markets, I have always believed it is important to embrace a gamut of market strategies to thoroughly understand market price action. Considering a variety of technical methods can provide greater confirmation of potential price action.

In fact, H. M. Gartley in his infamous book Profits in the Stock Market, emphasized such multiple confirmation strategies of technical methods, stating:

“Patterns must be used in conjunction with other technical working tools. The study of tops and bottoms, to be of greatest value, must be combined, and used in conjunction with the study of other working tools, such as Trend Lines, Moving Averages, Gaps, and particularly Volume, as well as Dow Theory and the general market phenomena which we call ‘Breadth-of-the-Market’ studies.”

The evolution of the Harmonic Trading approach has led to a more integrative perspective that is congruent with Gartley’s philosophy. Patterns—in this case, harmonic patterns—must be used in conjunction with other technical working tools. Of the vast array of indicators and oscillators available that I have researched, RSI represents the most effective measure in relation to the completion of harmonic patterns.

Although when talking about Relative Strength, sometimes people confuse the subject as relative to another index, such as the S&P 500. In this case, I’m talking about the Relative Strength measure that calculates the internal change of price movement, usually comparing the current price history with that of an average of a certain number of periods prior. (Typically, a 14-period average is calculated.) The readings of RSI measurements exhibit a number of unique technical traits in their own merit. For example, patterns that complete at extreme RSI readings can help to identify those special situations where the impending reversal signals the end of an extended trend. In many instances, I have noticed RSI readings that have formed similar complex structures in setups that possessed distinct price patterns. Even more compelling were situations where a Bearish Gartley, for instance, would develop on the price chart, while an indicator reading was showing a Bearish Three Drives structure. Both the price and the indicator reading structures completed at the same point within their own relative chart, serving to confirm the reversal. These are a few of the many distinct relationships that help to decipher price action within the context of harmonic price patterns. Furthermore, these unique phenomena can pinpoint the most critical turning points in the markets. Regardless of these obvious relationships, I was still looking for those exact situations where the dynamics of harmonic price patterns and technical indicators identified unique Potential Reversal Zones (PRZ).

RELATIVE STRENGTH INDEX (RSI)

The RSI was discovered by Welles Wilder in the 1970s. Wilder introduced RSI in his book New Concepts in Technical Trading Systems. In addition to the RSI technique, he introduced several other indicator and oscillator studies, including the Directional Movement Index (DMI). He presented a variety of unprecedented technical measurement strategies, but RSI is among his finest contributions to the field of Technical Analysis. Although it is properly categorized as a momentum oscillator, RSI is typically considered one of the more popular indicator studies available today.

The RSI was devised by Wilder as a means of calculating the change in momentum of price movement as it relates to a predetermined time period. The name Relative Strength Index is slightly misleading, as the RSI does not compare the relative strength of two markets, but rather the internal strength of the price action of an individual issue.

RSI is a price-following oscillator that ranges between 0 and 100. The RSI typically peaks above 70 and bottoms below 30, and it usually forms these readings before the underlying price chart. The RSI equation is derived by calculating the ratio of the average of X (number) price bars (days) day’s closes up divided by the average of X (number) price bars (days) day’s closes down. Although “X” can be any value, Wilder employed a 14-period factor in his computation. The equation is calculated as follows:

This equation quantifies the relative momentum of the current price action with that of 14 (X) periods ago. The extreme RSI readings provide excellent measures to the degree that the price action has persisted and the continued strength or momentum of the predominant trend. The true value of these readings occurs when the price and the indicator react at extreme areas. When the RSI tests an extreme overbought or oversold area at critical harmonic levels of support or resistance, the price action can reveal a great deal regarding the potential state of the predominant trend.

DIVERGENCE

The benefit of the RSI is most advantageous when compared to clear areas of support and resistance. The key technical event occurs when the price and the RSI diverge. In fact, in his book New Concepts, Wilder emphasized the importance of divergence:

“Although divergence does not occur at every turning point, it does occur at most significant turning points. When divergence begins to show up after a good directional move, this is a very strong indication that a turning point is near. Divergence is the single most indicative characteristic of the Relative Strength Index.”

I agree with Wilder. In fact, I believe that the RSI is the most reliable technical reading to reveal such divergence as it directly relates to price. Furthermore, the technical phenomenon of RSI divergence is particularly revealing when related to the completion of harmonic patterns.

As my research continued to explore this technical phenomenon further, I soon realized that the various RSI readings could be differentiated in much the same manner as harmonic patterns. I was able to define different types of extreme RSI readings and categorize these structures accordingly. This experimentation yielded significant technical information and helped to validate harmonic setups immensely.

RSI + BAMM = RSI BAMM

When applied to indicator readings, the BAMM concept differentiated various structures, especially in the extreme overbought and oversold RSI zones. The differentiated RSI readings at the completion of distinct harmonic patterns confirmed reversals and the overall validity of the setup in an unprecedented manner.

Although the BAMM principles could be applied to many technical studies, Relative Strength readings formed more distinct structures than any other indicator and provided the most reliable information in these divergent situations. As I continued to investigate the effectiveness of this strategy, one divergent technical situation, in particular, that I discovered worked unbelievably well within the Harmonic Trading approach.

RSI BAMM

The RSI BAMM is a method that examines the state of the indicator before considering the structure of the price action. As is the case with harmonic patterns, the RSI BAMM requires specific conditions to be met to validate a trade opportunity. Regardless of the extent of any price move or the structure that it forms, the RSI BAMM requires that a mandatory reading in the extreme overbought or oversold area occur to initiate the setup.

This condition creates an inherent problem within the Harmonic Trading approach, since the setup is dependent upon the RSI reading and not the price structure. For example, there are many instances where an extended predominant trend will seem to go on forever. Price action that enjoys a rally for quite some time may seem to never stop. Frequently, such well- established trends trade quite nicely within an upward sloping range and seem to be invincible. These situations can lull a trader into a complacent mindset, believing that the rally will last forever. However, the RSI reading can paint a different picture by assessing the relative extent of the price action. In other words, the RSI reading can indicate the degree of buying that has occurred. Although the RSI is an early signal, an extreme reading can serve as a potential warning sign of an impending reversal. When compared to the price action, clear areas of divergence can be defined.

I would like to take a moment and comment on a common misconception regarding indicators as a stand-alone technique for trading the markets. Many critics in the past have argued against the effectiveness of the RSI to be a reliable market signal. Some have argued that RSI does not possess credible technical information due to the fact that price action does not follow any consistent and predictable pattern following an extreme reading. Such universal application is not realistic, as anyone who really understands Technical Analysis knows this is not the proper analysis of such measures. All methods must be compared, contrasted, and analyzed with other approaches to determine the aggregate information provided from the price action. Whether to use trend lines, Stochastics, Candlestick reversal patterns, or any other method, it is imperative to have confirmation of multiple approaches to yield the most pertinent information for the best technical decision regarding any trade. In fact, in his book New Concepts, Wilder emphasized the importance of divergence:

“The Relative Strength Index, used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart reader. No single tool, method, or system is going to produce the right answers 100% of the time. A successful trader utilizes several different kinds of input into his decisions.”

A UNIQUE TECHNICAL SITUATION

Although the RSI BAMM involves many steps to validate this technical phenomenon and it might seem complex first, it is important to understand that this is truly a unique technical situation. The RSI BAMM is an advanced divergent condition where the RSI readings and harmonic pattern completions define extremely accurate technical levels and decipher the predominant trend in an unprecedented fashion. Although this advanced application of the basic tool that Welles Wilder developed decades ago does not appear in every market all of the time, when these conditions are present, the RSI BAMM is extremely accurate in defining precise levels of harmonic support and resistance. Furthermore, this technique quantifies the “indicative characteristic” of divergence in a manner that I believe even Wilder would find interesting.

I have accumulated a great deal of research on the various applications of the RSI. Starting with Wilder’s original work and examining a variety of other material, I believe that the RSI BAMM is an unprecedented application of this technical tool. Although many of the strategies do include some of the simple concepts involved within the Wilder’s original application—such as divergence, confirmation, and basic measurement techniques—the advanced application of the RSI with harmonic patterns represents uncharted territory for the Harmonic Trading approach, and for that matter, Technical Analysis.

The simple integration of the RSI represents a dramatic shift in the Harmonic Trading approach. Although the RSI BAMM may seem to stray from the principles of this methodology, the integration of the RSI adheres to the basic tenets of the Harmonic Trading approach. Fibonacci measurement techniques and pattern recognition strategies are still the primary basis that differentiate each situation and define the potential opportunity. I suggest to thoroughly study all aspects of this new strategy before attempting to implement it into real trading situations. Although the RSI BAMM requires many technical conditions to be met, pattern completions within this framework provide the significant trade signals and accurate evidence of the probable future price action well in advance.