Monday, March 19, 2012

RSI vs. Stochastic


MetaStock SPRS Series - Week 60 - TechniTrader® Stock Discussion for MetaStock Users: RSI vs. Stochastic - March 19, 2012
By: Martha Stokes C.M.T.

Today we are going to return to RSI versus Stochastic.

Both Wilder’s Relative Strength and Stochastic are price oscillators. Both have formulas that use only price and time with no volume analysis. Which should you use in the current market conditions? We are in a platform market condition. This market condition has many stocks moving in tighter price ranges for several days to several weeks then a sudden large move, either a gap or a big run, occurs and then the sideways action continues.

This type of market condition can frustrate swing and day traders who don’t understand the mechanisms behind this type of price action. Also, trying to swing trade a tight sideways price action can be hazardous to your capital base and monthly income.

In a platform market condition, RSI is the better choice. Here’s why:

The Stochastic formula is designed to identify overbought or oversold conditions as stocks move in a WIDE sideways pattern or within a trading range pattern. The overbought and oversold signals work ideally in Trading Range Market Conditions and at times Topping Market Conditions. Stochastic fails dismally during a Platform Market Condition.

Switching to RSI during platform market conditions can improve your profitability dramatically while reducing whipsaw trades.

Below, in October, Stochastic begins to fail to signal properly. A trough failure pattern occurs on Stochastic. RSI meanwhile is showing that an upside is underway. It correctly patterns upward as the stock moves up.


Chart 1

Stochastic continues to oscillate, signaling an overbought condition during a platform building sideways pattern. So many traders would attempt to either sell short or exit their trades on the buy side only to watch the stock continue to climb upward. RSI is working properly on this chart. Stochastic is giving false exit oversold signals.

It is critical that you use the proper indicators for the current market conditions. The Platform Market Condition is one of the most common and tends to last months at a time. Platforms are ideal for position trading and some specific swing style strategies.

SAR strategies fail during platform markets because the markets are not oscillating, the price action is a tight consolidation or platform. The platform is not a wide enough price range to net good consistent profits. Hence most platform markets create whipsaw trades for both swing and intraday traders. Understanding the phenomenon beyond the price action can help.

A platform market condition occurs during periods when the economy is recovering and stock investors are more cautious. Institutional investors are only buying stocks that have strong fundamentals and financial growth expectations.

Small lot traders, small lot investors, small fund managers are all buying speculatively. They rush in as a stock is moving, pushing price upward due to their lack of controlled order entries. I am not talking about a simple limit order which is a risky order to use in most market conditions. A controlled bracketed order is required in our modern electronic order system markets.

“Buy at Market” orders create market open gaps, fast runs on stocks intraday, and sudden profit-taking by pro traders who know how to trade against the smaller lots.

Summary:

Use the proper indicator for the current market conditions. If you do not adapt your indicators to the changing market conditions, your profits will diminish and you will experience more whipsaw trades. Those trades are NOT caused by market makers who have less and less activity due to HFT action. Whipsaws are caused by improper stock analysis and incorrect indicator usage.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
http://technitrader.com
MetaStock Partner

©2012 Decisions Unlimited, Inc.

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