Trader Education: The RSI is old, use this instead. Powerful strategy.
Oscillators are measured in two categories: bounded and unbounded. Bounded oscillators, like the RSI, only move between static values. For the RSI that is 0 – 100. Unbounced oscillators can move beyond 100 and zero. We are going to review two oscillators today. The RSI and the Composite Index.
The Relative Strength Index (RSI)
Created by the great J. Welles Wilder in the late 1970’s, the RSI is probably one of the most well-known indicators out there. I won’t go into all the details of its calculations, but suffice to say the RSI is an example of a momentum indicator. Technical Analysis has moved on and improved since the 1970’s. Enter the great analyst, trader and market wizard Constance Brown.
The Composite Index
The best way to think of the Composite Index as it applies to the RSI is to think of the RSI as Windows 3.0 and the Composite Index as Windows 10. Constance Brown discovered that the RSI, while it does create and detect divergences, does is not as accurate as it could be. It’s a bit of an oxymoron to say this but the RSI is a momentum indicator without any momentum calculation attached to it. The RSI actually misses a significant amount of important moves and even generates some bad moves. What Constance Brown did with the RSI is to input a momentum calculation within the RSI itself.
The RSI and the Composite Index together
One of the strategies that Constance Brown employed with the Composite Index was to compare the Composite Index against the RSI. When we look for divergences, we look for things like bullish divergence. Bullish divergence occurs when price creates higher-highs, but the oscillator shows lower-highs. When we use the RSI and the Composite Index together, we treat RSI like we would a price chart and the Composite Index is the oscillator. I create trend lines to show the bullish, bearish and hidden bull/bear divergences on the chart. Signals can be generated when the Composite Index line (red line) crosses below the two averages.
How powerful is this combination? Let’s look at some examples. But here’s the process I take. The image above is how I start. I make sure I don’t see any price action. I just want to see the RSI and Composite Index by itself and then draw the trend lines and some vertical lines near the Composite Index (red line) crosses above/below its averages. It should look like this:
Now, after we’ve done that let’s look at the price action itself and compare it to the levels we drew.
When used in conjunction with other forms of analysis, it becomes a powerful, powerful tool.