A Deep Dive Into Our Favorite Technical Indicator

At HX Research, we use many types of analysis to identify investment ideas.

This includes analysis of the company itself – called "fundamental analysis." It also provides analysis of the stock price and other data around the trading of the stock. This is called "technical analysis."

Today, we want to dive deeply into our FAVORITE technical indicator.

The story of one of the most essential tools in stock analysis begins 300 years ago in feudal Japan…

In the mid-18th century, the country was still under the control of the last feudal military government called the "shogunate" and hadn't yet actively opened full contact with the West. But despite mainly being closed to the outside world, Japan still engaged in an active foreign trade centered around rice.

The importance of the rice trade also led to the first “futures” market sometime around 1710. This system used coupons promising delivery of rice at a future time.

The invention of these coupons created one of the first times when a commodity or product was traded without that product's direct and immediate delivery.

Think about what we said in a recent issue of HX Daily, where we discussed the difference between stocks and companies… Remember, the actions of buyers and sellers influence the price of the stock more than the underlying company fundamentals do. These rice coupons had the same dynamic.

Previously, when you bought or sold rice, you exchanged money, and the rice was handed over. Now, months could pass before the exchange. This left the price of these coupons open to the influence of human psychology – just like the modern stock market.

This also allowed the emergence of one of the first market "wizards," who would become an early father of technical analysis – Japanese rice trader Munehisa Homma.

Homma lived in Osaka, worked as a rice merchant, and developed a unique insight into rice coupon trading. He identified that while the coupons eventually would represent the physical product, a trader's emotions could significantly influence rice prices.

In 1755, he wrote San-en Kinsen Hiroku, or The Fountain of Gold: The Three Monkey Record of Money, the first book on market psychology.

Homma was so successful with his analysis that he would go on to become an essential financial adviser to the government. (He's rumored to eventually have made the equivalent of $10 billion in today’s dollars!)

Like today’s modern stock market, Homma understood that the price movement was the combination of the decisions of thousands (now millions) of buyers and sellers – and it would be impossible to know or understand all of their motivations and opinions.

You could, however, "see" the result by looking at the asset's resulting price paid and various patterns in the price history.

These patterns mirror human behavior, and since humans are always ultimately behind the actions in the market (even in today’s robo-trading environment), these patterns repeat themselves. This presents an opportunity for investors willing to recognize and utilize them.

Many dismiss technical analysis as "not scientific enough" and essentially "voodoo." Still, they don't understand and accept the difference between stocks and companies. (This is also one of the main reasons that most investors routinely underperform the market.)

And while technical analysis is useful, many of the most commonly used patterns are relatively weak. A prime example of this would be support and resistance levels…

Traders ascribe value to their costs in a security. If a prominent base forms around a security's price level, this indicates that many people own the stock at that price. This may make them more reluctant to take action to sell the stock (forming a support level) or to buy it (creating a resistance level).

If investors own Company A at $10 per share and the stock rises, they will be reluctant to sell shares with no gain if it trades back down to that level – support.

But if shares of Company A trade below that level, those investors may look to minimize their losses and sell (thus increasing selling volume and breaking through support). Then, if the stock trades back up to $10, those who haven't sold yet are back to break even, so they decide to sell – resistance.

Following support and resistance levels is a popular style of technical analysis. Still, in our experience, it’s not particularly powerful or valuable.

However, the pattern we have found the most useful is one we’ve used as the primary driver behind our strategy here at HX Trader – the relative strength index (“RSI”).

This is computed with a two-part calculation that starts with the following formula:

The average gain or loss used in the calculation is the average percentage gain or loss during a prior period. The formula uses positive values for the average loss.

The standard is to use 14 periods to calculate the initial RSI value. For example, let’s say the market closed higher during seven out of the past 14 days with an average gain of 1%. The remaining seven days closed lower, with an average loss of 0.8%. The calculation for the first part of the RSI would look like the following expanded calculation:

Once 14 periods of data are available, we can calculate the second part of the RSI formula…

So… what does all that mean in plain English?

The RSI looks at the most recent trading period (past 14 days) and looks at what the balance of big “up” trading days is versus big “down” trading days.

A high RSI indicates many significant price increases relative to price decreases… and a low RSI suggests the opposite.

Why does this matter?

Remember that human beings ultimately govern trading in the stock market. As much as we would like to claim that we’re all entirely rational, we're still driven chiefly by emotions.

When we see a lot of significant "up" price movements in a stock within a short time, investors are excited. This may be justified (or not)… but like any time we get excited about something, it’s hard to maintain.

Think about the last time one of your favorite sports teams won a championship…

In that moment, you were beyond exhilarated. The next day, you couldn’t stop talking about it. A week later, it was still a topic of conversation… but not at the front of your mind. And within a couple of months, you were onto the next season, and it was just a pleasant memory.

This analogy is also how it goes with stock prices. In the moment, large, upward price movements can be sustained for some time, but eventually, they exhaust themselves.

This means that stocks with a high RSI (usually above 70) will likely stay the same after these periods. This doesn't necessarily mean they will go down, but sustaining that level of excitement is hard.

A high RSI is a valuable measure to monitor, but it’s not nearly as strong as the predictive nature of a low RSI…

The human body reacts to negative information much more strongly than positive information. This is a scientific fact resulting from millions of years of evolution.

The low RSI is a much better tool for this asymmetrical biological and psychological response.

When we identify stocks with a low RSI, we know that “panic” has set in. Our job is to determine if that reaction is justified and sustainable.

Interestingly, a low RSI can still predict a short-term rally even in the most extreme justifiable negative news situations.

The key is to identify those situations where the negative information that caused the reaction is short-term and will eventually be forgotten (or overwhelmed by positive information).

This is why we like to identify stocks in HX Trader with both a low RSI and a long-term positive uptrend.

In these situations, we know that the vast majority of the information has been positive for a sustained period (which is why the stock is up). Still, the company gets damaging information that suddenly pushes the stock down.

If that negative information is not sustained or material enough to overwhelm those longer-term trends of positive information, then it could be a good trading opportunity.

So, while fundamental analysis would argue that technical analysis isn’t based on fact, we would argue it’s based on physics much more than fundamental analysis is!