- Relative Strength Index is a simple measure to let you know when stocks are overbought or oversold, i.e. a measure of demand for an asset.
- Chaikin Money Flow is a measure of buying and selling pressure over a set period of time – an indication of demand for an asset.
- By knowing the demand strength for an asset, in our case ETFs and stocks, we can get a good approximation to when prices are cresting or troughing.
- Knowing about when prices will turn is the easiest way to take profits or begin to build positions.
“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”
John Tudor Jones
John Tudor Jones is one of the best stock market investors of all-time. His advice above needs to be taken in measured doses though, because we, are not he. However, the general idea of “buy low and sell high” is certainly captured in his quote. We should always remember to take heed of it.
As you have heard me say over and over by now in webinars, we want to avoid trading the middle of the market. If the stock market is in an uptrend without much chance of turning downward for more than a few days at a time, then we are better off sitting the small trades out and just riding the longer term trend up.
Conversely, if the stock market is cresting or already heading down, we do not want to be in any hurry to be buyers. We want to let the stock market fall to wherever it is going to fall and use our indicators to “buy when there is blood in the streets.”
Trading the middle of the market is for suckers. You are up against professionals and machines. Your odds of beating them are somewhere between slim and none. The Wall Street marketing machine keeps trying to convince unqualified people, using the hopes of quick riches, to day and swing trade. Ask why. Hint: it’s not out of altruism.
Trading Against The Retail Masses
We are “position traders.” That is, we are looking for investments that can carry us through an entire sub-cycle of a bull market or an entire cyclical bull market. There are some opportunities for swing trades (trades lasting weeks or a few months), but not many. In either case, position trading or swing trading, out entries will almost always be contrary to the prevailing market sentiment.
In other words, we take the other side of the bet from the retail masses when their bets get crowded. In most cases, we are aligning ourselves with institutions who also invest against retail investors.
The telltale signs of when the retail masses have finally jumped on a trade is that they experience a case of acute FOMO (fear of missing out) and buy a stock or fund as institutions start to trickle their shares off to the retail masses. In essence, big rich investors selling to not so rich small investors.
This cycle plays out over and over. Always try to inoculate yourself against FOMO with a dose of FOGYAK (feat of getting your assets kicked).
In the past several years, the relationship of institutions abusing retail has morphed into some institutions abusing retail and other slower moving institutions. This is important for us to know who to watch. Mutual funds and indexes are the slow moving elephants. We can do well trading against those.
Here are two simple to learn technical tools to use for trading against the retail and slow moving institutions:
Relative Strength Index
The Relative Strength Index or RSI is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.
The concept of a divergence is important for us to understand. This is when the price of an asset continues to rise even as RSI begins to fall. This is an early warning system.
When the daily measure of RSI begins to fall, a stock’s or ETF’s price will start to fall within about a week, sometimes the next day. You will need to be aware of support levels to understand how much downside risk there is when RSI becomes extreme, that is, over 70, and then stops rising.
The daily measure of RSI is most commonly used by swing traders. We will use it from time to time, but the weekly is more appropriate for us. A daily chart measures in daily time increments, the weekly in weekly time increments (pretty straight forward).
When we look at a stock or ETF we will want to see RSI starting to move up from an oversold position. We will not always be fast enough to buy when it rises from say 27 to 33, but if we get in below 50, which is the midpoint as it rises, we will often get a good price.
In general we want to see a stock get close to 30 to consider it oversold. As I said above, because some institutions are front running slow institutions, the old definitions of what is a signal are a bit skewed today. That’s why it’s important to completely understand the underlying fundamentals of an asset. In the end, fundamentals are your trump cards.
Chaikin Money Flow
Money flow tells the real story of how much demand there is for a stock. With both positive and negative measures, it should be pretty apparent that negative numbers are bad as that means there are more sellers than buyers. A stock or ETF cannot rise intermediate or long-term with more selling than buying. Simple supply and demand.
The concepts of divergences comes into play here as well. If money flow starts to fall while price is rising, then the price will generally follow downward soon. Again, a change in money flow is a signal that something is about to change with price.
The importance of measuring different time frames is important with money flow as well. The daily is a measure for short term traders. The weekly and monthly tell you the real big money trend. We want to be on the side of the big money.
If there is a short-term trend out of money flow out of a stock, i.e. daily, that will generally be followed by a correction in the price. If the weekly and monthly are both trending up though, without being extreme, those short-term pullbacks are good times to buy.
MACD is an extremely popular indicator used in technical analysis. MACD can be used to identify aspects of a security’s overall trend. Most notably these aspects are momentum, as well as trend direction and duration.
What makes MACD so informative is that it is actually the combination of two different types of indicators.
First, MACD employs two Moving Averages of varying lengths (which are lagging indicators) to identify trend direction and duration. Then, MACD takes the difference in values between those two Moving Averages (MACD Line) and an EMA of those Moving Averages (Signal Line) and plots that difference between the two lines as a histogram which oscillates above and below a center Zero Line. The histogram is used as a good indication of a security’s momentum.
Signal line crossovers are what we want to look for. We can look for the instance just before a crossover occurs as well if we want to be aggressive.
From troughs, we want to see the MACD line start to move up and through the signal line to indicate a bullish move in price. At peaks, we have to be wary of the MACD line starts to move down thorough the signal line which usually means a move down in price.
I use MACD as a confirmation of changes of direction when my overbought/oversold signals are given. MACD is not an overbought/oversold signal itself.
Let’s take a look at the Invesco Solar ETF (TAN) as it is in our ETFavorites VSL and has some volatility as a bit of a battleground asset class.
This is the daily chart. See how RSI and CMF have both fallen and price has followed. The MACD confirms the downward momentum as well with the MACD crossing below the signal line.
Looking back a bit on the chart, you can see that TAN was overbought just prior. This is a good example of a pullback off of short-term overbought condition in the short-term.
What about the longer-term though? Let’s take a look at the weekly and monthly charts.
Here is the weekly chart. Notice I extended the chart to include 5 years for context since we are measuring using longer time frames. What do you see? What do you think it means?
What I see is that TAN became overbought for a moment and is pulling back. The money flow approached, but never quite reached the same highs as those of the previous five years though, indicating there is more upside at some point.
Understanding fundamentals jumps into the analysis here. What do we know about the solar sector? It is growing fast and governments are pushing solar development. We should expect the high money flow levels to be exceeded eventually.
The monthly chart expands on the story.
The RSI is just coming off of being overbought again. Being overbought frequently in the past year indicates that there has been big money entering the solar sector. We know this to be true as we read the headlines and reports.
We can see that there has been buying pressure for a year in TAN. Money flow has generally been positive for a year and has been moving up for longer than that. That explains the rise in price.
We also see that the buying pressure never became extreme. This indicates to me that there is still skepticism by the retail sector. What do we want to do when the retail sector is skeptical about something that institutions are looking for reasons to buy?
Disclosure: I am/we are long TAN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own Bluemound Asset Management, LLC, which is a fiduciary, fee-only Registered Investment Advisor. I publish separately from that entity for self-directed investors. See relevant terms and disclaimers at the website of Bluemound Asset Management, LLC. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.