Contrarian Trading with RSI

By Apurva Sheth, Editor, Profit Hunter  ·   02 Mar 2016   ·   ARCHIVES

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Apurva Sheth

I am sure you've heard that 'the trend is your friend' or that you should 'trade with the trend' many times from technical analysts and traders. That's because it's good advice. Most money is made when markets are trending. And to benefit from the trend, you have to trade in its direction.

But that's only one side of the coin. Markets do not trend all the time. They move up and down quickly, and a large part of the time is spent sideways, consolidating the gains or losses. There are times when the markets or stocks simply do nothing and trade choppily in a very tight range, giving no indication at all of the trend.

Hence it is said that whenever you spot a trend you should befriend it and trade with it. The catch is trends do not last forever. The trend is your friend only until the end.

And that's when you have to step aside from the herd. If you don't, you'll be butchered in the slaughterhouse. This is where most of the people get it wrong. A lot of people think contrarian trading is simply doing opposite of what the majority is doing. You can't make money if you do this always.

You have to be a contrarian only when the trend is nearing exhaustion and about to reverse. Let me warn you beforehand: Contrarian trading isn't for everyone. It requires nerves of steel to go against the majority. And you need to have a proper method and the conviction and discipline to follow it fully.

Today I will share with you one of the methods I often use to make recommendations to our Swing Trader subscribers.

This strategy is based on a momentum indicator called the Relative Strength Index, or RSI. But before I tell you more about RSI, let's focus on momentum.

What is momentum?

Momentum refers to the 'velocity' of a price trend. Velocity is speed in a given direction. Speed describes only how fast an object is moving, whereas velocity gives both the speed and direction of the object's motion. Traders use various indicators that help them measure the speed and direction of a security. These indicators help them make their trading decisions.

The RSI is one such indicator, and it is extensively used by traders. It shows how strongly a stock is moving in its current direction. The RSI does this by comparing the magnitude of recent gains to recent losses, generally over the last 14 days.

The RSI oscillates between zero and 100. A security is considered overbought when the RSI is above 70. An overbought reading suggests that the stock has run up a lot and could reverse direction or halt. A security is considered oversold when RSI is below 30. An oversold reading suggests that the stock has fallen a lot and could reverse direction or halt.

Under the normal course of trading, the RSI oscillates between 30 and 70 and occasionally exceeds to 20 and 80. And sometimes the RSI crosses even these levels. This is when one should step aside from the herd and look for contrarian opportunities.

I will explain how I do this step by step.

1. Select a group of stocks
   
   First, select a group of stocks you want to trade. Some traders prefer to trade only Nifty 50 stocks while others are open to trading a bigger universe and opt for a bigger group such as CNX 500 or BSE 500. At Swing Trader, we follow a strict volume-based criteria to define our universe of stocks. We only select stocks that have an average daily turnover higher than Rs 4 crore for the last six months. This is to ensure sufficient liquidity.


2. Find out RSI values of these stocks
   
   Once we have our group of stocks, I find out the latest RSI values of all them. I use 14 days as my parameter. I also find out the lowest RSI level in the last one, two, three, and ten years.


3. Sort stocks with the lowest RSI values
   
   The real work starts once we have the RSI values for all the stocks across different time frames. Now one can sort stocks in an ascending order depending on their most recent RSI values. We are looking for stocks whose current RSI value is below 20. These stocks have been beaten down abnormally hard.


4. Check RSI values for other time frames
   
   Once I have a list of stocks ready, I compare their RSI values across different timeframes. I compare the current RSI with the lowest RSI value recorded across multiple time frames. If the current RSI reading is closer to any of these readings, then the stock is worth looking at. The closer the current RSI is to the previous lows, the better. In fact, I would go one step ahead and look for stocks hitting a ten or 20-year low on the RSI. I would keep these stocks in my radar.


5. Filter stocks
   
   Once I have a broad list ready, I go ahead and filter stocks based on their chart patterns. I also consider important support and resistance levels that can come in to play and halt the fall of the stock. Finally, I have a list of a select few stocks I would like to enter near specific levels.


6. Wait for diverging signals
   
   Stocks often do not move up immediately after the RSI has hit a fresh low. Instead, they continue to drag lower, but the RSI moves up. The RSI forms a higher low when the price hits a lower low. This is a diverging signal. Here the momentum indicator does not confirm with price. This is a sign that a reversal could be coming anytime soon.


7. Take entry with a suitable stoploss
   
   Finally, I would recommend a buy when everything is in place and the price action gives an indication of a bottom reversal. I would look for confirmation from candlesticks on lower time frame to enter the stock with a suitable stoploss
   
   Here's an example of a stock when I first implemented this strategy.

Contrarian Trading in Siemens India
Siemens India was in a sharp downtrend at the start of 2013. It had nearly halved from its July 2011 high of 947. The year didn't start well for the stock as it had lost almost 30% in the first two months.

The daily RSI was continuously dropping lower. It hit its lowest ever level of 9.39 on 4 March 2013. By then, it was already in my watchlist. After hitting a low 494, the stock suddenly took a sharp U-turn and moved up almost 20% in a fortnight. This rally was short lived as it moved back below the previous low in a few days.

However, the daily RSI did not fell any lower. It remained above 30 when the price hit a fresh low. This was a clear signal of a divergence and that a reversal could be coming soon. As you can see in the chart above, the stock eventually did manage a reversal and touched a swing high of 628 from a low of 466.

This is how I have used RSI as a contrarian trading tool. And I must say I am quite satisfied with the signals this approach has given me over the years.

Do you like taking contrarian trades? What strategy do you use? Share your views in the Club or share your comments here.