It's been a rough year for financial counters, with banks hard hit by the fallout out of the subprime crisis and the subsequent credit crunch. Investors are fearful and no one seems able to say for sure when the worst will be over.
Technical analysis might be a way to help an investor steer through these rocky waters. Chart analysis uses price behavior to understand a market. Technical analysis delves into the figures of price behavior and tears them apart using methods derived from statistical analysis. The objective is to identify the points where there is a higher probability of a change in the trend. A powerful tool in chart analysis is the Relative Strength Indicator (RSI).
The RSI compares the internal strength of a stock by looking at the average of the upward price change and comparing it with the average of the downward price change. The results are expressed as a percentage, providing the upper and lower boundaries.
Now let's apply this to a well known bank in Asia. A 30 percent price retreat is either a buying opportunity or a four-bell "must get out" alarm. After a retreat from the high of HK$153.50 many people felt Hong Kong-listed HSBC (HK;5) was a good buying opportunity. They were caught in what smug analysts are now calling a 'sucker rally' as the stock rebounded from near HK$108 and peaked near HK$134. Traders using RSI technical analysis collected a 24 percent return from this rally.
It was a 'sucker rally' for those who believed it was part of a general new uptrend recovery. The current price rebound from near HK$112 now faces a more difficult task to rise above HK$134 because those who did not sell near this level in May will be anxious to sell as the price nears this level again.
HSBC hasn't been immune from the global bad taste created by subprime slime. But technical analysis of the price activity highlights the high probability of trading opportunities from both the long and short side. These analytical methods provide advance warning of developing trend changes. This is important because here, price activity is not defined by strong support or resistance levels.
HSBC has a love affair with the RSI. They walk hand in hand in the market, clearly signaling their intentions. Rather than lifting the carpet to find traces of subprime slime, traders can use the RSI to decide on the timing of trend changes.
RSI divergence analysis is extremely useful because it identifies changes in sentiment. Divergence develops when the trend on the price chart is moving in the opposite direction to the trend on the RSI display.
A rising price trend is defined by connecting the highs of the trend and matching this with the peaks on the RSI as shown in area 1. A falling trend is defined by connecting the lows of the trend and matching this with the lows on the RSI as shown in area 2. Both area 1 and area 2 show an RSI divergence and a significant trend change soon develops.
This method comes with an important warning. It is only the activity above 70 or below 30 on the RSI indicator that is used for calculating RSI divergence. Activity between the lines has no significance when looking for RSI divergence patterns.
HSBC has a textbook relationship with RSI. The trend change develops very rapidly after the RSI divergence is confirmed. This is unusual because the most important weakness of RSI divergence analysis is the casual relationship it has with timing.
RSI divergence signals can develop weeks before a trend change so they are usually used as a warning signal for developing trend change. The RSI divergence signal is confirmed with a move below or above the long term trend line. The HSBC love affair with RSI has reduced this timing lag.
Chart analysis does not tell us if HSBC is an active member of the subprime club or just a collateral debt obligation groupie. Chart analysis does allow traders to more effectively manage the risk of trading HSBC because good warning is given of developing trend changes.
If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.
CNBC assumes no responsibility for any losses, damages or liability whatsoever suffered or incurred by any person, resulting from or attributable to the use of the information published on this site. User is using this information at his/her sole risk.