Understand the RSI
A simple observation is made in an uptrend, each closing price is likely to be higher than the previous one, and in a downtrend, each closing price is likely to be lower then the previous one. The official definition of relative strength index is:
Where RS is the ratio of the number of points gained (close to close) on each ‘up day’ to the number of points lost (close to close) on each ‘down day’, during the past ‘n’ days.
A simplier way of looking at this can be derived by rearranging the above formula:
Where points gained / lost are calculated on a close to close basis for the last “n” events.
Note: Since the RSI is calculated using a fixed number of events (usually between 8 and 14), even if the price is currently very stable, the value of the RSI can still change significantly if there has been a sharp price movement ‘n’ events ago.
So, for a 9-day RSI, the change in price today has exactly the same effect on today’s value of the RSI as the price change 10 days ago (which has just dropped out of the RSI calculation).
As mentioned above, one of the advantages of oscillator analysis is to point out short term market extremes. For this purpose, the constant 0 to 100% RSI scale is very useful in order to compare different situations, and it gives the possibility of identifying ‘danger zones’ corresponding to overbought and oversold situations.
Generally, an RSI value above 75% indicates an overbought situation whilst a value below 25% indicates oversold. However, the user should be flexible here, as 80% & 20% seem to be more appropriate in strong trending markets, while values 70% & 30% may be used in ranging markets.
The oscillator’s first move into the overbought area (oversold for a downtrend) should only be considered as a warning. Indeed, any strong trend produces extreme values for the RSI, and in strong markets the oscillator line may remain in an extreme zone for some time.
A possibility of a divergence situation exists:
- When the oscillator moves for a second time into the extreme zone
- When this second move fails to confirm the price move into new highs (or lows), forming a lower high (or higher high) on the oscillator.
The second (or third!) time the oscillator moves into the extreme zone and diverges from the price line, the boundaries of the extreme zone may be used to generate trading signals. Long positions should be liquidated when the oscillator is above the 75% line and a crossing back under the 75% line can then be used as a sell signal. The same applies to short positions around the 25% value.
NB: Caution is urged when trading on these signals, as the oscillator may enter the extreme zone more than twice. i.e. You may have sold as the RSI crossed below the 75% line for the 2nd time, but it is possible that the price may then recover to make an even higher high (after only a small decline) as the RSI re-enters the overbought zone. It is therefore advisable to seek confirmation from other tools to avoid potential bad trades.
Relative Strength Index Trading Techniques
- The effects of changing the period of the RSI
- Extreme readings
- Failure swings
- Chart patterns
Changing the period of the RSI
A change in period of the RSI has a surprising effect. Lengthening the period flattens the lines (as expected) but the turning points stay in the same place. With moving averages in mind, this is slightly unexpected. Lengthening a moving average has the effect of smoothing it (flattening) but also the turns move to the right.
This does not happen with the RSI. The RSI line flattens but the turns take place in the same place. You cannot spoil the signals that an RSI gives by changing its period – you can only make it more or less clear.
For this reason, traders often change the period. Usually they shorten the period to make it clearer. Popular periods are 9 or 10, although we sometimes use 5 periods. This is the lowest you can go without the calculation breaking up and the turns moving position. This is the clearest an RSI can give.
Extreme Relative Strength Index Readings
Extreme RSI readings can signal the likelihood of major tops and bottoms. Although the exact levels are subject to debate or optimisation and are affected by the period used. Wilder recommends using using 70% and 30%.
While some traders use the simple break of these levels as a sign of the market being overbought or oversold, but this is fraught with danger. In trending markets the market can go overbought early and stay overbought for a long time as the market powers ahead.
Divergence between process on a chart and RSI strongly suggests that prices will be reversing. If prices are rising or flat and RSI is decreasing, look for a turn downward in prices. If, on the other hand, prices are declining or flat and the RSI is increasing, expect prices to turn and move higher. This can be one of the most reliable RSI signals.
These are chart patterns. A failure swing is defined as follows: The RSI rises into the overbought zone, declines to a lower level (fail point), rallies and the sell signal is generated when the RSI breaks down through the failure point. The reverse is true in the oversold zone.
Chart Patterns on Oscillators
In general, this is trend line analysis. Here we look for trend lines in the RSI to break in advance of those in the price chart itself. This is entirely natural as momentum precedes price.
Note how the RSI lines break first as the momentum is lost before the price changes direction.
As with failure swings and divergences, chart patterns will be clearer with a lower sample period such as 5 or 9 bars.
How to Trade with the RSI
So we’ve been through how the Relative Strength Index works, so how do you actually make money from it?
The RSI is a secondary indicator. This means that it should be used in conjunction with at least a primary indicator (trend line, support & resistance, price pattern, volume). This should be used to confirm what the primary indicator is showing.
It doesn’t matter whether you are using it to determine direction or as a trigger, as long as it is used along side another indicator it is fine.
How to determine direction with the RSI
Determining direction is done by using higher time frames to understand where the market is going and then dialing down into lower time frames to identify an entry and exit.
Steps to identifying direction with RSI:
- Go to a higher time frame
- Choose your primary indicator
- Compare whether your primary indicator and the RSI are aligned in the direction
- What is the primary indicator telling?
- Does the RSI confirm this?
- What is the primary indicator telling?
Does the RSI confirm this? Yes
The RSI does confirm this because:
- It is not oversold, suggesting that there is still downside in this market.
- Its highs and lows confirm that of the price, which as highlighted above are making lower highs and lower lows, exactly the same way as the RSI.
Notes: There has been a bounce in both the RSI and the market. This is to be expected and should just be helping you find a place to get in.
How to use RSI as a trigger
Again, to hammer home the fact that the RSI is a secondary indicator, you must have a trigger using a primary indicator first, and for the RSI to simply confirm that trigger.
Once you have decided on direction, you will need to look for an entry, a reason to buy or sell the market at a certain price. You can receive an RSI buy or sell signal before and after your primary indicator gives you a trigger signal. The two scenarios are as follows:
- RSI gives you a sell signal before the primary indicator. You must wait to take the trade until the primary indicator gives you the signal.
In the above example, the RSI was overbought but crossing back over the line gives a sell signal. The market is yet to break the trend line and so there is no trade until the latter occurs.
- The primary indicator gives you a sell signal but the RSI has not. You are fully in your right to take the trade without the RSI but should you want extra confirmation, you can wait to take the trade after the RSI gives you a sell signal.
Using RSI without a primary signal
In the example above, there are three sell signals on the RSI but no primary sell signals (break of the trend line). This shows that you must wait for the price to show you where it is going and not to solely rely on the RSI.
Steps to using RSI as a trigger:
- Go to lower time frame
- Choose your primary indicator
- Decide whether you must have both primary and secondary indicators aligned before entering the trade
- Wait for primary indicator trigger
- Has RSI already given a signal? If it has, enter the market
- If the RSi has not given a signal, wait for signal before entering the market
Remember that the RSI can give signals in various different ways.
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