Tuesday, May 25, 2010

One RSI, Two Rubber bands!

Here is an easy way to understand RSI and its effect on price!

Imagine two tight rubber bands are tied horizontally on the rsi chart.

one, along 0 rsi level

and the other along 100 rsi level.

The rsi is tied to both these rubber bands.

Also, the rsi can only move within these 2 rubber band boundaries!

Now, whenever the market sentiment,liquidity and/or fundamentals whip the bulls,

the price starts shooting up.

Along with the price, rsi also starts moving up.

When rsi moves up, the lower rubber band attached to its body starts getting stretched!

More the price moves up, more the rubber band stretches!

Stretch, stretch,.....more stretch!

Only the force of the trend keeps the price attached to rubberband rsi from snapping back!

It is easier for the market forces to stretch the rsi rubber band from 50 to 60 than from 60 to 70.

Stretch from 70 to 80 requires more force and momentum.

Stretch from 80 to 90 is very tiring!

Beyond 90 is anybody's guess!!

Degree of momentum required to stretch the rsi for next 10 points is always higher than the last 10 points!

The more the rsi rubberband is stretched, the more dificult it becomes to stretch it further.

And easier it is to snap back!

This increasing difficulty of stretching the rsi rubber band is because of many reasons

One of them is that the bears are just looking for a chance to call bulls' bluff and make money!

Also, with every rise in price, the greed starts making way for the fear!

The same thing is available now for higher price and hence lesser enthusiasm.

The momentum slows, the volumes drop.

Nobody, including sensible bulls wants to overdo!

Consequently, we see the rubber band rsi pull back.

RSI tries to pull back the price with it.

How much the price retreats depends upon the momentum left in the sentiment, liquidity and fundamentals!

Once the rubberband rsi takes a few steps back, it is now less stretched.

It is now ready to take the next stretch! Provided market forces have not exhausted.

This cycle of stretching and relaxing continues till all reasons with sentiment, liquidity and fundamentals are finished!

Then this rubber band gets the chance it was looking for....

and pulls back with vengeance!

Along with it comes down the price!

Now the sentiments, liquidity and fundamentals take the other side.

The same earlier story is repeated, albeit in the reverse direction.

But remember, the elasticity and hence the stretching the 14/2min rubberband is much easier than 14/30min which is further easier than that of 14/1day!

That is why, when RSI 14/30min rsi rubberband is stretched to, say 7, it is less easier to stretch it further and easier for it to snap back - less or more!

Now you can understand the reason behind "failure swing point" when the rsi makes a lower second peak and hence fails to "hold" its stretch thus resulting into snapback (trend-reversal)!

Almost any rsi pattern and behaviour can be understood with this rubber band analogy!

So, predict the movement of the price with the stretch and behaviour of the rsi rubberband!

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