FINRA Series 3 Free Practice Questions 83

The RSI spends most of its time fluctuating between 25 and 75. At extremes, it moves under 25 or over 75. These are the standard oversold (less than 25) and overbought (greater than 75) areas.

To determine the RSI, a trader selects the number of days; nine is the standard, or default, in most programs

To calculate the nine-day RSI, you need to average the change of the previous nine up days and divide this number by the average of the change of the previous nine down days. The RSI ranges from just above 0 to just under 100, but it is extremely rare to see a number close to either of these extremes. The RSI spends most of its time fluctuating between 25 and 75. At extremes, it moves under 25 or over 75. These are the standard oversold (less than 25) and overbought (greater than 75) areas.

How do you use the RSI? When this number gets too small or too large, it is time to put your antenna up. The market could be getting close to a reversal point. Some traders attempt to buy when the RSI wanders into oversold range and sells in the overbought range. My opinion is that if you attempt to do this, you better have deep pockets. At times (range-bound markets), this can be an excellent way to pick tops and bottoms. However, in the major moves and at extremes (the most profitable time for the trend follower), the RSI can remain in the extreme ranges for long periods of time and for quite a few points. (And, hey, it’s “only” points, right?) This is the major drawback of the RSI: It works in normal markets, but when the market is in the blow-off or panic stage, it can remain in overbought or oversold territory for an extended period and become quite costly.
Still, I do believe the RSI is a useful tool, but only when used in conjunction with other indicators. You need to know what type of market you are in (trading range or trending, young or mature). If you can determine this, the RSI can help you identify the point in the life cycle of the market. The RSI tends to get high in the mature stages of a bull market and low in the mature stages of a bear, but there is no magic number that signals the bottom. In fact, I’ve found it is a good
practice to watch for the RSI to turn up after it falls under 25 to signal a bottom and vice versa for the bull. Yet, even this tactic tends to lead to numerous false and money-losing signals because the RSI is a coincident indicator. It moves with a price. A minor upswing has to turn the RSI up.

Stochastics
Stochastics are another popular oscillator. While George Lane is generally credited as the developer of stochastics, some in the industry contend that Ralph Dystant was actually the creator of this widely followed indicator. The stochastics formula is a bit more complex than the RSI and is readily available for those who want to see the mathematics. I won’t discuss it here (you can let the computer figure it out for you as most other traders do), but I will talk about the basics of how to interpret stochastics data.
The stochastics formula measures how the close impacts the trend. Here is the theory: In bull markets, the close is more likely to occur near the day’s high, and
in bear markets, the close is more likely to occur near the day’s lows. The way the market closes determines how the stochastic trends. In essence, stochastics
is a measurement of how the most current close relates to where prices have been during the period under study.
Stochastics consists of two lines: the %K, which is more sensitive, and the %D, which is slower moving. As with the RSI, the trader can choose the number of days for the formula. Shorter terms (5 days is popular) are sensitive and act quickly but lead to many more whipsaws. Longer terms (14 days is widely used) identify longer-term moves and eliminate some of the whipsaws of the shorter variety.

Overbought is generally considered to be a value in excess of 80, and oversold is less than 20.

Overbought is generally considered to be a value in excess of 80, and oversold is less than 20.

They can be used as in the RSI, but they tend to give better signals when they diverge from price (as with the RSI). Divergence can precede the market. Bullish divergence is when prices hit new lows, but the stochastic makes a higher low than its previous low. Bearish divergence is when prices hit a new high, but the stochastic makes a lower high. Both of these occurrences can give strong indications of market tops and bottoms. Traders also look for the stochastic lines to cross to exit an existing position or enter a new one. (See Figure 8.25.) The best signals come when divergence is present, and then the %K line crosses the %D line that confirms the divergence.

Elliot wave analysis
Ralph Elliot was an accountant who developed his theory on market cycles in 1939. Basically, Elliot believed that there is a “natural order” to the markets and
that they travel in predictable cycles. He believed that the market rallies in five waves when in an uptrend and falls in three-wave corrective moves. When in a
downtrend, the main trend is five waves down, with three-wave corrective up moves. This five-wave pattern is made up of three odd-numbered waves—1, 3, and 5—which are connected by two corrective waves—2 and 4. Each major odd-numbered wave can be subdivided into five waves, and corrective waves can be broken into three parts (the ABC correction). (See Figure 8.26.)

Point and figure charts
The point and figure (P&F) is another type of price charting; the unique thing about P&F is that it ignores time. Time is irrelevant; only price matters. Xs and
Os indicate price signals. A P&F chartist uses Xs to illustrate rising prices and Os for falling prices. As long as the price is rising, Xs are added. Os come into
play when they are dropping. The decision to start a new column of Xs or Os is based on the market making a price change of a certain amount designated by the technician. This would be a box. The technician also must designate (in addition to the size of each box) what determines a reversal. For example, a popular reversal size is three boxes. So, if you use a scale of 10 points for cattle, a reversal size would be 30 points. The values for the box and reversal are arbitrary, depending on how sensitive the trader wants the P&F chart to be.
The larger the box size and reversal values, the less sensitive the chart is and vice versa. A 1¢ box for wheat is obviously more sensitive than a 10¢ box. If the
chart is too sensitive and the boxes too small, you increase the chances of being whipsawed by insignificant fluctuations. If the boxes are too large, you miss out
on significant portions of some moves and take too much risk. Figure 8.27
illustrates a typical P&F chart.