The Relative Strength Index – RSI is one of the most commonly used indicators in the stock or forex market. Traders rely on this technical indicator, which is also an oscillator that tells you whether a market is overbought or oversold.
It is a leading indicator and a momentum indicator used to measure price changes to evaluate whether a currency is overbought or oversold. The RSI measures the speed and change in direction of price movements and can also be used to identify the general trend of a trade.
It is intended to chart the current and historical strength or weakness of a market based on the closing prices of a recent trading period. The RSI measures the velocity and momentum – the rate of the rise or fall in price.
The calculation for the RSI formula is as follows: RSI = [ 100 / (1 + (Average of Upward Price Change / Average of Downward Price Change))] For a full explanation of this calculation it is recommended you refer to the developer, J. Welles Wilder’s book, New Concepts in Technical Trading Systems, published in 1978 and in Commodities magazine (now Futures magazine), June 1978 issue.
The RSI can be set at different levels for different variations of trading. It oscillates between 0 and 100 with 50 being the mid point and typically used on a 14 day time frame. The traditional set up is when it is above 70 it is overbought and when it is below 30 it is oversold. Besides identifying the general trend, it will show divergences and failure swings, support and resistance points etc. The RSI will also give you false signals and it is for this reason the RSI should be used only as an indication of the trend and used with other indicators, signals, signs to confirm your analysis of your trade.
In an uptrend or bull market, the RSI will remain in the 40 – 90 range with the 40 – 50 zone acting as support. In a downtrend or bear market the RSI will be between the 10 – 60 range with the 50 – 60 zone acting as resistance. This will vary depending on your RSI settings and the strength of the market. The RSI will form chart patterns that might not show the underlying price chart – support, resistance, double tops, bottoms and trend lines. If the chart price makes a new high or low that is not confirmed by the RSI, this is called a divergence and can signal a price reversal.
Top/Bottom Swing Divergence
If the RSI makes a lower high and then follows with a downside move below a previous low, this is called a “Top Swing Failure” and if the RSI makes a higher low followed with an upside move above a previous high, this is called a “Bottom Swing Failure”.
“Wilder thought that “failure swings” above 70 and below 30 on the RSI are strong indications of market reversals. For example, assume the RSI hits 76, pulls back to 72, then rises to 77. If it falls below 72, Wilder would consider this a “failure swing” above 70.”
Powerful Trading Concept – The ‘Swing Failure’, ReubenBlameyFX
Andrew Cardwell noticed that uptrends generally traded between RSI 40 & 80, while downtrends usually traded between RSI 60 &20. Cardwell noticed when markets changed the direction of their trend the RSI undergoes a “range shift”
Cardwell also noticed that a bearish divergence in an uptrend usually leads to a brief correction instead of a full reversal in the trend. He took this as a bearish divergence as a sign confirming an uptrend and a bullish divergence was a sign confirming a downtrend.
The RSI is prone to giving false signals due to sharp price movements causing it to spike up or down repeatedly. This could also signal an entry or exit point when compared with other signals. Often at times the price will continue to extend well beyond the point where the RSI first indicated the market as being overbought or oversold. Always wait for confirmation of a trade continuing or reversing and use with other indicators taking everything into consideration. Placing a trade when the RSI reaches an overbought or oversold position can backfire on you and put you quickly in the negative for too long a period of time where recovery is either non existent or if you do recover, you make a minimal gain that only tells you that your move was not worth the risk.
Identifying Trading Setups Using RSI
Here are some steps to implementing an intraday forex trading strategy that employs the RSI and at least one additional confirming indicator:
- Monitor the RSI for readings indicating the market is overbought or oversold.
- Consult other momentum or trend indicators for confirming signs of an impending retracement. For example, if the RSI shows oversold readings, a retracement to the upside is anticipated though not necessarily confirmed.
It is considered good practice to look at initiating a trade looking to profit from a retracement if one of these additional conditions are met:
- The moving average convergence divergence (MACD) has shown divergence from price (for example, if the price has made a new low, but the MACD has not and has turned from a downslope to an upslope).
- The average directional index (ADX) has turned in the direction of a possible retracement.
If the above conditions are met, then consider initiating the trade with a stop-loss order just beyond the recent low or high price, depending on whether the trade is a buy trade or sell trade, respectively. The initial profit target can be the nearest identified support/resistance level. Investopedia, How to Trade with an RSI
Entering on an overbought/oversold area with the RSI, as well as other oscillators, can be counterproductive in strong trending environments. Extended trends can keep the RSI in an overbought/oversold area for a long period of time.
Traders looking to buy on an RSI crossover from oversold values would be a disaster. Instead look to sell the market when the RSI is oversold in a downtrend and buy when the RSI is overbought in an uptrend.
RSI Indicator Secrets: Powerful Trading Strategies to Profit in Bull & Bear Markets, Rayner Teo
For example on an 8 hour chart let’s say the price pushed up, the RSI remained above 50. As momentum shifted, the RSI dropped below 50 indicating a bearish reversal and drop it did for 300 pips. Everything you read or hear about the RSI will tell you that traditionally traders set their RSI at 14 period setting. (the indicator looks back 14 bars on whatever graph you are on to create its reading. This may be the wrong setting for your trading. Short term traders usually use a smaller period, eg: 9 period rsi to replicate shorter term movements in the market. Long term traders may use a higher period setting, eg: 25 period RSI for a longer term period. The longer period term will also cut out a lot of the noise that happens in a shorter period term setting .
If you had a nine period RSI line side by side with a 25 period RSI line. While there may not seem like much difference at first glance, pay close attention to the centerline along with crossovers of the 70 and 30 values. The RSI nine at the top of the graph has considerably more oscillation compared to its RSI 25 counterpart.”
John Hayden, in his book “RSI: The Complete Guide” states that you should be looking for signals of 66.66 for bull markets and 33.33 for bear markets which is a little less than the usual 80/20 or 70/30 readings. John states these are the true numbers that measure bull and bear trends and not the standard numbers we have been taught.
RSI Defining Trend
“In the above chart example, the RSI shifted from a weak position to over 66.66. From this point, the RSI stayed above the 33.33 level for days and would have kept you long in the market for the entire run.”
In a downtrend you want to make sure the trade does not cross 66.66.
Trading RSI Trend Lines Made Easy (Stocks & Forex Trading Strategy)
When trading trend lines you are not looking for overbought/oversold conditions. You are looking for a break in momentum of the prevailing trend has ended or a new trend on the way. You look at the changes in price rather than the peaks and valleys. The RSI measures the surge in prices.
Placing trend lines on the RSI provide an additional level of precision as well as an additional trade set up because the signals are leading instead of lagging. Trading trend lines on the RSI works best on the higher time frames, although you can do this on all time frames.
We need the RSI trend line to be broken & the price to be trading below the trend line.
Momentum always goes ahead of the price. The breakout of an RSI trend line usually precedes the breakout of a trendline on the price chart providing an advance warning of a reversal, therefore, recognizing the breakout of an RSI trend line.
The RSI is a lagging indicator by nature which is why you lose so much of the profit as often the first few bars are the most profitable.
A leading indicator will give you the profit from the beginning but leading indicators will also give you fake outs, which is why it is important to analyze the price. You need to draw key support & resistance levels.
Many traders use it as a reversal signal, however a conservative way is to trade the main trend only.
RSI Settings: 14 Default Setting
9 Short Term Trading
21 or 50 Long Term Trading
Find the best approach according to your trading style. Maybe take your trade after the first candle after it breaks the trend line.
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