No investor wants to cut his hands trying to "catch a falling dagger," but everyone wants to buy a bargain. Here's a very simple strategy that will help ensure you're buying "on the dips," and not just being foolish.
No investor wants to cut his hands trying to “catch a falling dagger,” but everyone wants to buy a bargain. Here’s a very simple strategy that will help ensure you’re buying “on the dips,” and not just being foolish.
The strategy has an incredible batting average, as you’ll see in the charts below. You simply buy when the daily Relative Strength Index (RSI) moves to a “buy” signal.
The RSI indicates the price momentum of a stock or a market relative to its own recent past. The indicator is very popular and is on just about every charting service (free or paid) I have ever seen.
We’ll use the S&P 500 to illustrate. The RSI data is seen in the bottom portion of each chart below. The RSI buy signal is reached when the RSI moves from below to back above the “30-line.” (It’s not enough for the RSI to simply be below 30; it must move back above the 30-line to be a buy signal.)
The 30-line is the lower horizontal line.
I drew a vertical black line from the RSI buy signals in the S&P 500 so you can see where the market was at the time of the signal, and what happened afterward.
The indicator works well in both bull markets and bear markets. But it works best as an entry signal in bull markets. So in addition to the five-year chart above, I’ll show you how this strategy performed in the two previous bull markets.
Here’s the bull market that began in 2002 through the top in the summer of 2007.
And below is the bull market from 1994 to mid-1999. In each chart there are also a few times when the RSI came within a hair of moving below 30 but bounced back up. In the chart below I used red lines to point that out.
You can also see that in 1998 there were two apparent RSI buy signals. Although the S&P 500 dropped about 10% after the first one, the second one a few months later would have gotten us in near the bottom.
If you’re looking to create similar charts of your own, there are two other important things to keep in mind.
First, we have been studying the daily RSI today. This is the RSI that we would find if we added the indicator to a daily chart. If you look at a weekly chart, it will give you the weekly RSI, which is also useful, but it’s more useful for very long-term signals. For the results similar to what’s above, be sure you’re looking at a daily chart when you view the RSI.
Also, the settings I’m using are the default settings on most charts, which is 14 time periods. You can see in the chart below that I circled and pointed to the place you’d typically find that setting.
For those thinking of buying on the dips because they believe the bull market still has a ways to go, the RSI can be a good reality check.
Chris Rowe is a member of the Investment U Research team.
The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.