This time the Finex glossary discusses technical indicators again.
This indicator is one of the most popular, which helps traders to identify entry points for buying (when securities are oversold), as well as points for selling (sell points) – when securities are overbought.
The relative strength index is still widely used today. Many traders also use it to look for divergences against possible upcoming trend changes.
Understanding the Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. The RSI was developed by J. Welles Wilder, a mechanical engineer turned technical analyst.
The RSI oscillates between 0 and 100 and is usually measured over a 14-day period. The RSI is considered overbought when above 70 and oversold when below 30. As long as the trend remains strong, the RSI can remain overbought or oversold for long periods of time.
Profit from trading with the Metatrader 4 platform.
RSI often forms chart patterns that may not be visible on the underlying price, such as double tops and bottoms and trend lines. With RSI we can also see the levels of support/resistance.
In an uptrend or bull market, RSI tends to stay in the range of 40 to 90 with the 40-50 zone as support.
During a downtrend or bearish trend, RSI tends to stay between the 10 to 60 range with the 50-60 zone as resistance.
This range will vary depending on the RSI settings and how strong the underlying security or market trend is.
If the underlying price chart shows a new high or low that is not confirmed by the RSI, this divergence may signal a price reversal.
The RSI tops down below the low, it means that a Top Swing Failure has occurred.
If the RSI makes a higher low, followed by a move up above the previous high, it means that a lower swing failure has occurred.
Trading with RSI
Adapted from Investopedia, here are the steps for trading using the RSI indicator for intraday traders with one additional indicator:
Monitor the RSI for readings that indicate the market is overbought or oversold.
Look for other momentum or trend indicators to confirm signs of a retracement (a temporary price reversal in the midst of a developing trend). For example, if the RSI shows an oversold reading, it means we should be prepared to expect an upward retracement, although at the same time it is not necessarily confirmed.
To take advantage of a retracement, make sure one of these conditions is met:
The Moving Average Convergence Divergence (MACD) has shown price divergence (for example, if the price makes a new low, but the MACD does not and changes from a downtrend to an uptrend).
The Average Directional Index (ADX) has changed to a potential retracement.
If the above conditions are met, you should consider initiating a trade with a stop loss past the current low or high, and you should also check whether the trade is a buy or a sell.
The initial profit target can be determined from the nearest identified support/resistance level.
How to determine stop loss and take profit
How to calculate RSI
A very technical and complicated explanation is needed to calculate the RSI as a whole.
We must read Wilder’s explanation for ourselves which is contained in his 1978 book entitled New Concepts in Technical Trading Systems.
However, there is a fairly simple formula, namely:
RSI = 100 – [100 / (1 + (Average price change up / average price change down)]
Need to know more…
We already know that in relative strength index conditions overbought when above 70 and oversold when below 30.
However, these levels can be adjusted to better suit the price movement of the security you want to observe.
For example, if the RSI of a security consistently reaches above 70 or below 30 without predicting to change the price trend correctly, traders can adjust the upper point to 80 and/or lower to 20 for more reliable trading signals.
Traders should remember that during periods of very strong trends, the price of a security can continue to rise for a long time.
The time after an oscillator such as the RSI indicates overbought conditions in the market. The same warning applies to prolonged downtrend price movements that can occur after the RSI indicates the market is oversold.