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How to tell if the market is about to change direction

Posted by Matt Dalgleish on 22 December 2015
Matt Dalgleish

A recent Mecardo cattle analysis article titled “Are we in for a short-term EYCI correction?” outlined some common methods often used in technical analysis (also known as charting) when forecasting market price trends.

We always aim to deliver short, punchy market analysis and outlook articles. As such, there is often limited space to explain the actual techniques we use to analyse markets. We thought it may be useful to publish a series of more in-depth blogs on some of these technical analysis tools that describes their use in more detail for readers not familiar with charting.

The purpose of this blog is to give the reader a better understanding of the Relative Strength Index (RSI) and how it can be used, particularly when identifying situations where prices might be ready for a correction.

Firstly, we need to clarify what technical analysis actually is, and how can it help understand the market.

Image - Mecardo commodity market analysis

What is technical analysis?

The terms charting and technical analysis are often used interchangeably. They describe when a graph of historical price data is used to try to predict future price movements and determine market trends.

"Technical analysis is where a chart of historical price data is used to try to anticipate future price movements"

However, there is a subtle difference between charting and technical analysis.

Strictly speaking, charting refers to more traditional techniques that use graphs on price and volume alone to look for recognisable patterns that repeat. Technical analysts combine charting with the use of more mathematical/statistical analysis. They use a wide selection of indicators to assist them with their analysis of the market.

Chartists and technical analysts believe that the collective knowledge of all market participants and each participant’s assessment of the state of the market is demonstrated by their decisions to buy or sell. Therefore, these collective behaviours form the basis of supply and demand within the marketplace at a given time, and is ultimately reflected in the price.

To some degree, a chart is a measure of the mood of the crowd and, as such, technical analysis is a study of human mass psychology. Within charting circles, there is a belief that market participants collectively repeat the behaviour of the participants that preceded them.

Because this crowd behaviour repeats itself so often, they hold that recognisable patterns will develop on a chart. Recognition of these patterns can allow the chartist to identify trends and have a higher degree of success in their forecast of price movements.

If the collective decision-making of market participants, including their assessment of all relevant fundamental factors, is indeed reflected in price, it holds that an analysis based on historical price movements and associated price indicators can be used as a window into the fundamentals that are driving the market.

The use of technical analysis is particularly useful when markets have a myriad of fundamental factors that can affect them. This is because the most relevant and reliable indicator that shows us what is happening in the market on a fundamental level is price – and this is what the chartist/technical analyst focuses their attention upon.

Understanding the Relative Strength Index (RSI)

In the study of physics, momentum is defined as the rate of increase or decrease in the speed of an object. In a similar vein, momentum in financial markets is the measure of the speed of a trend. That is, whether a price trend is accelerating or decelerating when compared to recent price moves.

Chart - EYCIThe relative strength index (RSI) is a momentum indicator. It is used to chart the underlying strength or weakness of a price trend based on the closing prices of a recent trading period.

The RSI calculates momentum as the ratio of higher closes to lower closes. Commodities that have had more, or stronger, positive changes have a higher RSI than commodities that have had more, or stronger, negative changes.

The RSI is measured on a scale from 0 to 100, with high and low levels marked at 80 and 20 (see pale grey lines in figure 1). Traditionally, technicians would describe a market as being “overbought” when the RSI is above 80 and “oversold” when the RSI is below 20.

Overbought vs oversold

A market that is described as “overbought” is referring to an upward trending market that is running out of momentum to continue to push higher and is expected to experience a correction lower.

Conversely, an “oversold” market is a market that is in a downwards trend that is running out of momentum and is indicative of a market that is ready to stage a correction higher.

Figure 1 highlights some historical price movement in the Eastern Young Cattle Indicator (EYCI) that illustrates situations when the RSI was either overbought (above 80) or oversold (below 20).

At this stage, it is important to point out that using RSI purely as an indicator of an oversold or overbought market is fairly simplistic. And while it can be useful in identifying a market losing momentum, it does not always signal a major change in trend.

In fact, a market that is range-bound can be the enemy of a strategy that simply uses RSI levels above 80 as a sell signal and RSI levels below 20 as a buy signal. This is because a market that consolidates in a pattern of sideways, range-bound trading will have the effect of RSI moving towards the level of 50, displaying neither overbought nor oversold bias.

Consider the situation where a market displays an overbought momentum with RSI above 80 but, rather than stage a correction lower, consolidates instead. This can mean that the RSI signal showing the market was losing momentum is less reliable and, as the RSI moves back towards 50, can create room for the original trend in price to continue higher.

Indeed, the two orange circles in figure 1 indicate a scenario in the EYCI in the first quarter of 2010 where the RSI went above 80 signalling an overbought market (indicating that it is due for a correction lower).

However, instead of the correction, the market began to consolidate in a tight range and the RSI drifted off towards 50. After the consolidation was complete, the EYCI was able to make another push higher in accordance with the original trend. The RSI slowly moved back towards overbought territory once more, albeit at a higher price than the original overbought signal in quarter one of 2010.

So why use RSI?

A more reliable use of the RSI as a potential change in trend can be to look for divergence patterns between price behaviour and the RSI indicator itself.

The two key patterns to identify when looking for RSI/price divergence are known as “bearish divergence” and “bullish divergence”.

Chart - ESTLIBearish divergence refers to a situation where the price of a particular commodity is in an uptrend and, as the price makes higher highs, the RSI indicator for the same period fails to make new highs. This scenario can be seen in figure 2 when the Eastern States Trade Lamb Indicator (ESTLI) made a series of three new highs in the middle of 2004 while the corresponding RSI for the same period made lower highs.

The divergence between price and RSI displays bearish divergence, signalling a market that is losing its upwards momentum. In this instance, price would be expected to stage a change in trend and begin a new downtrend.

Chart - EYCIConversely, bullish divergence refers to a situation where by the price pattern of a commodity is displaying a down trend and, as the price makes lower lows the RSI indicator for the same period fails to make new lows. This is highlighted in figure 3 when the Eastern Young Cattle Indicator (EYCI) made a two lows during the 2002 season while the corresponding RSI for the same period made higher lows.

The divergence between price and RSI in this instance signals bullish divergence, signalling a market that is losing its downwards momentum. In this situation, price would be expected to begin a fresh uptrend.

Just one tool in the toolbox

As highlighted in the cattle analysis article titled “Are we in for a short-term EYCI correction ?” technical analysts will use more than one charting tool/methodology when assessing the potential direction for market moves. When a combination of technical analysis tools begins to point to a similar outcome for price, the chartist can have a higher degree of confidence that their projections for price will result in success more often than not.  

Read our RSI analysis of cattle prices

Topics: General information, Market analysis

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