Using Moving Averages and RSI to Analyze Market Indices
By Nick Sudbury*
Posted: Feb 17, 2006
One of the most popular and straightforward indicators used in the analysis of market indices is the moving average, which, as the name suggests, is simply the average closing level of an index as measured over a specified period of time.
Moving averages are lagging indicators and are used to highlight the direction of the trend, such that, if an index moves below its moving average, it is in a downward trend and visa versa. Views differ as to the best period to use, but, for longer-term traders, the 50- and 200-day moving averages are among the most widely watched.
The chart of the FTSE 100 taken from MarketCenter.com provides a good example. From the moment the index crossed back above its 50-day MA in late August, the market entered a clear bullish phase that lasted until the end of September.
Moving averages are good for staying on the right side of a trend, but they are limited in that, by definition, they will lag behind the price action. When you look at the chart, you see that the FTSE index peaked on October 3 at 5515 before falling to a low of 5130 on October 21.
However, when you use the moving average, the bearish trend will not have been confirmed until the FTSE falls below it on October 12, by which time, the index has already lost more than 150 points. There is an even longer delay of 200 points between the low and the establishment of the bullish trend when the index crosses back above its MA.
A similar lag is also apparent from the chart of the Dow. The index hit a low of 10156 on October 13, but it did not manage to rise above its MA until the end of the month, by which time it had already added some 270 points.
The way to deal with this lag is to include a leading indicator in the analysis. One of the most popular is the Relative Strength Index or RSI. This compares the number of days that an index finishes higher against the number that it ends lower. It ranges in value from 0 to 100 and is generally considered to be showing overbought conditions if it reaches 70 or more, and oversold if it approaches 30, although some traders prefer to use 80 and 20 respectively.
Perhaps the most common calculation is the 14-day RSI. The FTSE and Dow charts both highlight the way that this will lead a lagged indicator such as the moving average.
With the FTSE, for example, the October low coincided with an oversold measure of 25.5 from the RSI, which signalled that a reversal was imminent. The picture on the Dow isn’t quite as clear-cut although the October low came as the RSI was approaching oversold territory. This is why some experienced traders believe that the 14-day RSI is slightly too long and prefer the 7-day for its greater responsiveness.
The most important point to keep in mind is that an overbought / oversold indicator such as the RSI should be used as a secondary technique, with the key decision being based on the price action.
For example, if an index is falling, the fact that the RSI is low does not constitute a signal in its own right. The best way to interpret the reading is that it is merely a warning to show that there may be a reversal coming soon.
Traders need to take this lesson to heart. If the price is falling, the index is in a downward trend and buying on the back of the RSI would be trading against the trend. The safest course of action would, instead, be to wait for a confirmation from a change in the price action. This is especially so, given that one of the main dangers with the RSI is that, in a strong trending market, it can signal overbought or oversold conditions too early.
This article was originally published in Shares magazine and is reprinted (and modified) with permission from Nick Sudbury.Note:The streaming charts screenshots in this article were captured from eSignal's MarketCenter LIVE product. To find out more about how you can get streaming, real-time quotes from all the markets, plus streaming charts, news and Market Depth, go to: www.marketcenterlive.com.
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