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A Traders Helping Traders

EXCLUSIVE SPECIAL REPORT

by

Erich Senft, CTA

Author of “The Truth about Trading Support and


Resistance – How to Trade Commodities Like a Pro”
Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Limits of Liability/Disclaimer
The author and publisher of this book and the accompanying materials
have used their best efforts in preparing this program. The author and
publisher make no representation or warranties with respect to the
accuracy, applicability, fitness, or completeness of the contents of this
program. They disclaim any warranties (express or implied),
merchantability or fitness for any particular purpose. The author and
publisher shall in no event be held liable for any loss or other damages,
including but not limited to special, incidental, consequential, or other
damages. As always, the advice of a competent professional should be
sought where necessary.

This manual contains material protected under International and Federal


Copyright Laws and Treaties. Any unauthorized reprint or use of this
material is prohibited without express written permission of the author.

DISCLOSURE OF RISK: The risk of loss in trading futures and options


can be substantial; therefore, only genuine risk funds should be used.
Futures and options may not be suitable investments for all individuals,
and individuals should carefully consider their financial condition in
deciding whether to trade. Option traders should be aware that the exercise
of a long option would result in a futures position.

Hypothetical performance results have many inherent limitations, some of


which are described below.

No representation is being made that any person will, or is likely to,


achieve profits or losses similar to those shown in this manual. In fact,
there are frequently sharp differences between hypothetical performance
results and the actual results subsequently achieved by any particular
trading method.

One of the limitations of hypothetical performance results is that they are


generally prepared with the benefit of hindsight. In addition, hypothetical
trading does not involve financial risk, and no hypothetical trading record
can completely account for the impact of financial risk in actual trading.
For example, the ability to withstand losses or to adhere to a particular
trading program, in spite of trading losses are material points which can
also adversely affect actual trading results. There are numerous other
factors related to the markets, in general, or to the implementation of any
specific trading program which cannot be fully accounted for in the
preparation of hypothetical performance results and all of which can
adversely affect actual trading results.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 2


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Why RSI?

Of all the different secondary indicators that traders have to choose


from, in my opinion, RSI is one of the best.

RSI stands for Relative Strength Index; however the name does not
adequately describe what the indicator does. It does not really
measure the “relative strength” of anything; rather the indicator gives
you an idea as to the internal pressures affecting a market.

In other words, RSI can help you get a “feel” for what other traders
are thinking.

RSI is also useful because it mimics what other indicators are telling
you as well…and more.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 3


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Here is a chart of RSI with Slow Stochastics overlaid. Notice that both
indicators rely on overbought and oversold regions to give you a
sense for where the market is currently trading.

Notice how the circles identify where both indicators would have
given buy and sell signals; although the signals may have been
generated differently (more on that in a minute). Here you can see
that RSI and Stochastics follow each other pretty closely.

Similarly RSI follows MACD, another popular indicator quite closely.


MACD is a popular indicator because it is rarely wrong, but the
reason it is rarely wrong is because it has considerable market lag.
Even so many traders use MACD to plan their trades.

RSI is actually a little more sensitive than MACD and will give buy/sell
signals earlier.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 4


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Many traders look to MACD to identify divergences between the


indicator and prices. As you will see in a moment, RSI is also an
excellent tool for picking up on divergences.

Momentum is another indicator that has been gaining popularity


among technical traders. Like MACD, Momentum tries to capture the
market momentum, hence the name.

As you can see from the chart, MOM and RSI follow each other pretty
well. In fact, MOM seems to fill in under the RSI line. This is helpful to
remember when you are looking at RSI: that the space between the
RSI and the 50% level on the RSI indicator, will roughly approximate
the market momentum.

So you can see how you can use RSI to gather the same information
that is given on different indicators, but there is more. RSI lends itself
particularly well to the support and resistance trader because it helps
us identify important support and resistance levels.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 5


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Important Point to Remember

Always remember and never forget RSI, like any secondary indicator,
is usually a lagging indicator. This means that it normally follows
what is happening on the price chart.

Therefore you should place your primary emphasis on analyzing the


market based on what you know about support and resistance and
use RSI to give you hints, or help confirm your decisions.

RSI Settings

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 6


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Technical traders always seem to be “tweaking” their settings on the


indicators hoping to gain some sort of edge; however since I normally
use RSI to gauge market sentiment, I stick with the standard settings.

I have RSI set on a 14 period average, although the 9 and 25 period


averages are also popular among traders. The shorter 9 period
average with be a little more choppy but will give you even faster,
albeit less reliable signals; whereas the longer 25 period average will
have a tendency to smooth out the line and give you fewer, but more
accurate signals.

If you are curious I encourage you to try the different settings and find
one that is right for you. I used to use a 21 period average before;
however I went back to the 14 period as I found it just as predictable.

Likewise I stick with the standard 70/30 overbought and oversold


parameters. Some traders like to use the 80/20 lines to determine
when the market is overbought and oversold.

This is not as important for our purposes since we will be using more
than just the overbought and oversold levels in our analysis, but here
too, feel free to experiment. You may find that the more extreme
levels are to your liking.

The concept of overbought and oversold is an attempt to measure the


condition of the market. The reasoning is that everything in the
market has a tendency to “normalize”.

Therefore if a market is overbought (too many buyers), then prices


should go lower. Likewise if a market is oversold (too many sellers)
prices should react by going higher.

It is important to note however, that simply because a market is


overbought or oversold does not mean that prices will immediately
reverse and go in the opposite direction. During periods of extreme
supply or demand, markets can remain in the overbought or oversold
areas for weeks or months at a time.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 7


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Even so, it is helpful to keep an eye on the market as it approaches


these regions as in most cases the market maybe finding resistance
soon.

How to Use RSI

The following chart shows a recent trade in the sugar market.

Notice how the RSI indicator is following prices down. Note too how
the peaks, highlighted by the dotted vertical lines, mirror the peaks on
the price chart.

One of my favourite tools for analyzing the RSI chart is a simple


trendline. By drawing a declining trendline along the peaks on the RSI
indicator we can see that the market is currently at a “test point” as
highlighted by the circles on the price chart and the RSI chart.

So what is this telling us?

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 8


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

RSI shows that while prices continued lower, RSI (or the market
sentiment) was rejecting going lower. In fact as the market was
approaching the oversold region around the beginning of June, RSI
was starting to head slightly higher.

Now RSI shows that the market is either ready to break the
downtrend or rebound off the trendline and continue lower still.

Why would this be?

Well a quite look through the chart shows a considerable amount of


support earlier in the life of the market as highlighted by the yellow
rectangular box.

No wonder RSI is showing that the market is at a “test point”!

So how would you handle this?

Well, given what we have learned from the RSI chart we know that
the current price is the “test point” price. Therefore we have one of
two options:

1. either prices will bounce off the RSI trendline and continue
lower through support, or
2. prices will bounce off support and break the RSI trendline
heading higher.

When you take that into consideration that the market is near the
oversold region and seems to be rejecting going lower, as well as the
substantial support just below the market at the 618 area, it seems
reasonable to assume that RSI will break the descending trendline
and prices will head higher.

Therefore you could plan your trade to enter the market long above
the high of the last day. This means that if prices do not rally off
support and instead head lower, then your order will not be engaged
and you will suffer no loss.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 9


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Here is the market a few weeks later…

Notice that the market did exactly as we expected and broke through
the RSI trendline, which is shown as a dotted line in this chart. The
original test point is still highlighted by the yellow circle on the RSI
and price charts.

As the market advanced for the next few weeks, notice how RSI
formed a channel in the process. This is my second favourite tool to
use on the RSI chart.

In fact you should anticipate the RSI indicator forming a channel as it


moves from one region to another. By bracketing the movement of
the indicator in a channel it becomes possible to use the upper and
lower boundaries of the channel as targets.

This is exactly what is happening in this chart.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 10


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

The market is currently trading at resistance in the 721 area. RSI


shows that if the indicator continues as it has, it should attempt to
reach the upper boundary of the channel as highlighted by the small
white circle. This will be the next “test point” for the market.

So now that we know that the market is nearing another “test point”
we can look to the price chart to try and determine where that might
be. There are two significant resistance areas above the 721 region
which may coincide with the RSI test point: 740 and 755 (not
highlighted).

Because 740 is the first resistance to be encountered we will use that


first, and if it fails then we can be surer about the 750 resistance
holding.

We also know that the market is getting into overbought territory and
will be quite severely overbought if it reaches the white circle;
therefore we might expect the market to reverse from here and send
prices lower.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 11


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

A few days later…

Notice how the market continued higher and found the 740 resistance
area, but what happened to RSI?

RSI did not follow suit. Rather RSI began moving in the opposite to
prices as shown in the shaded pink area of the price chart. This is
DIVERGENCE and is one of the strongest signals you can get from
RSI.

When RSI and prices begin moving in opposite directions for a period
of time keep a close watch on the market because you are almost
guaranteed a change in direction!

Now I know some of you are asking about the breakout that occurred
near the end of July and is shown by the black arrow. On this day the
market breached the lower RSI trendline which might have hinted of a
change in trend.

As a result of the breakout we could have planned to enter the market


below the low of the day that caused the breakout knowing that if
prices got below this level then RSI and prices should continue lower.

Look at what happened the day after the black arrow however. While
it appears that the market got below the low of the previous day, it is
in fact only 2 ticks lower. You know from Appendix A in the manual
that 2 ticks in sugar is close enough to be resistance; therefore our
entry order would have been at least 3 ticks away to make sure the
market did not get snagged by resistance, which is exactly what
happened here.

This is why it is important that you try to make the market come to
you before it engages your order. It is a simple way to reduce the
possibility of “whipsaws” in your trades.

As you can see RSI rebounded after the breaking of the trendline and
prices continued higher to resistance at 740. Notice how the market
reacted to the 740 level by retreating slightly the next day (last bar on
chart)? Notice too how RSI is still showing divergence and is about to
leave the overbought area of the indicator?

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 12


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

These are two very strong sell signals. In light of this you could plan
to enter below the low of the last day, allowing at least 3 ticks below
the low, with reasonable confidence that the market will continue
lower.

A few days later…

Here is the market a couple of days later. Note how the market found
the 50% profit target in only one session! That is a fast market, even
for sugar.

The best part is that you could have taken multiple contracts with
confidence in a trade like this since RSI and resistance were both
strongly suggesting that prices would come down. By placing exit
stops above the high of the previous day you would have had only
$125 risk per contract and would have profited nearly $500 per
contract for a risk/reward ratio of 4:1.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 13


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

One other point I want you to notice from this chart is that RSI has a
tendency to “hook” at important support and resistance levels. This
can aid you in identifying when the market might pause or stop and
reverse direction.

Early Signals

While RSI is primarily a lagging indicator, on the odd occasion RSI


can tip you to what will happen before prices do. This is another
situation where you can take a trade with greater confidence.

In this chart you can clearly see how RSI has already broken the
trendline while prices still remain in a channel formation. Knowing this
you would give preference to a breakout below the channel,
especially when the breakout is as substantial as this one.

Likewise, knowing that RSI has already dipped lower, you could enter
the market short below the low of the last day instead of below the

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 14


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

bottom of the channel. This would enable you to both get into the
market at a better price and have less money at risk.

RSI can also form other types of breakout formations including


sideways channels and pennant formations which will sometimes
give you a breakout clue before prices actually breakout of the
formation.

Overbought and Oversold

One last point to bear in mind when dealing with the overbought and
oversold regions on the indicator, is that the market does not have to
reverse simply because the market is overbought or oversold.

Sometimes the market can spend several days or even weeks in the
overbought or oversold region and all that time prices can continue to
go higher or lower.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 15


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

In this chart you can see that Live Cattle spent the better part of July
and some of August in the overbought region of the RSI indicator.
During this time prices kept on advancing without any significant
retracement in price.

Notice however that there was a “retracement” on the RSI indicator


as highlighted by the yellow circle. This pullback on the indicator
would lead me to believe that the market has been “refreshed” and
therefore higher prices could now continue…which they did.

When the market does trade in the overbought or oversold areas of


the indicator I like to be on the lookout for what is called a “failure
swing”.

A failure swing is similar to a 123 top/bottom formation where the


indicator will form a new high (low) which will be the 1 point. This will
in turn be followed by a reaction move, forming the 2 point. After this
the indicator will again test the 1 point but not exceed it, making a 3
point in the process.

Once the indicator breaks through the 2 point it would be a confirmed


buy/sell signal, as the case may be.

In this chart the indicator has broken below the 2 point which would
lead you to believe that a short position is in order. You could initiate
such a position by placing a sell order below the current low and
enter short only if the market was able to exceed the low.

This would add a little protection to your position by making the


market come to you before engaging the order.

Final Thoughts

When using RSI remember that it rarely makes a straight line from
overbought to oversold. Expect the indicator to hook and use these
hooks to draw trendlines and channels to help give you clues as to
what might happen next.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 16


Special Report – RSI: The Support and Resistance Trader’s Secret Weapon

Most importantly however, always remember that while RSI can be a


very useful indicator for helping to determine market direction, it is still
only a secondary indicator.

Your primary information should be coming from the price charts


themselves and the support and resistance contained therein. Always
use the charts for your analysis and use RSI to give you hints as to
what you might expect the market to do.

Use RSI more as a confirmation tool than a primary decision making


tool and you will never go too far wrong.

© Erich Senft 2003 www.tradershelpingtraders.net – All Rights Reserved 17

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