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Article Title: "Momentum Indicators Can Flash False Signals "
Author: CHRISTINA WISE
Section: Investor's Corner       
Date: 12/29/2006
Following secondary market indicators can be dangerous, especially when they send false signals.

Some price-momentum indicators, such as the Relative Strength Index (RSI), use a stock's recent price changes to calculate overbought and oversold signals.

The idea is that a stock that's overbought will soon break down, while a stock that's oversold is ready to rally. In short, they're designed to flag extreme moves. The RSI may also suggest that the market is overbought at the start of a bull run, or oversold when a bear market starts.

The problem is that big price swings - either up or down - can trigger false signals.

A stock that surges out of a base may prompt the RSI to give an overbought reading. An investor taking that cue may forgo buying the stock. In reality, a breakout is a clear sign that big institutional investors are piling into the stock and that its price will probably continue to rise.

Copa Holdings shot out of a base Aug. 16. Its RSI stood at 71 on the day of its breakout, then shot up to a 98 in less than two weeks. Relying on the RSI measure alone would have made you think the stock was overbought and caused you to sell (a reading above 80 is considered overbought).

On the flip side, a stock that sinks in brisk trade will likely continue to fall. But the RSI will often tell you that the stock is oversold and therefore primed to climb.

The RSI shouldn't be confused with IBD's Relative Price Strength Rating, which is based on a stock's 12-month price performance. It also differs from the Relative Strength line, which measures a stock's performance relative to the S&P 500.