Sunday, April 22, 2012

Relative Strength Index (RSI)

Introduction to RSI indicator

Relative Strength Index (RSI) - is another great momentum indicator developed by Welles Wilder.
Standard period settings for RSI is 14 periods, which can be applied to any time frame.
RSI indicator compares the average of up and down closes for a specific period of time.

Quick Summary

Trading with RSI indicator involves the following signals:
• RSI moving above 50 level — uptrend is confirmed, below 50 — downtrend is confirmed.

• RSI peaking above 70 level — market is overbought.

• RSI staying above 70 level — uptrend is running strong.

• RSI exiting 70 level — downtrend is underway, or at least a correction down is due. (Opposite for RSI falling below 30.)

• RSI trend line breakout - early warning about chart trend line breakout.

• RSI diverging from price on the chart — an early warning of a possible trend change.

Let's review each of these RSI signals below.

How to trade with RSI indicator

RSI indicator is often referred as an overbought/oversold indicator, however, this is not exactly accurate. RSI doesn't provide Buy/Sell signals upon reaching oversold/overbought areas, there are certain rules, which help to identify the right timing for entries and exits. 

 Readings above 70 indicate an overbought market, while readings below 30 indicate an oversold market.

However, once RSI advances above 70 it is not yet a signal for an immediate Selling, since RSI may stay in overbought area for a long-long time. In fact, when a strong uptrend develops, readings above 70 are just a beginning of a great upward move; an opposite is true for a downtrend and readings below 30.

In order to enter at the right moment (on the true market reversal) Forex traders should wait for RSI to leave its overbought/oversold area. For example, when RSI goes above 70, Forex traders would prepare to Sell, but the actual trade will take place only when RSI crosses down below 70.
Opposite true for an oversold RSI: once RSI goes below 30, traders wait for the indicator to come out of an oversold area and rise above 30 before placing a Buy order.

Forex traders also use 50 level of the RSI indicator, which separates buying forces from selling forces on the market. Certain trading strategies use RSI 50 level to confirm Long and Short entries by looking at a positioning of the RSI in relation to its 50 level.

RSI trend lines

RSI indicator has got another handy feature: Forex traders use RSI to draw trend lines.
While RSI's trend line stays intact, it confirms that a trend holds well.

 With RSI trend lines Forex traders are able to receive a much earlier warning about upcoming trend changes since RSI trend lines witness a breakout few candles earlier than chart trend lines.

RSI trend lines are especially useful on large time frames. 

Trading divergence with RSI indicator

Another way to exploit RSI is to take advantage of RSI divergence signals.

When RSI approaches 30 look for a bullish divergence => slowly rising RSI versus already declining prices.

When RSI approaches 70 traders watch for a bearish divergence, which occur when actual RSI readings begin to decline while prices continue climbing up. RSI Divergence suggests that a current momentum is over and traders should look to protect their profits and be ready to trade in the opposite direction.

The best way to learn about any indicators is to read original works of their creators.

Therefore, let's turn to the book where J. Welles Wilder tells about his research on RSI indicator:

"(3) Failure Swings: Failure swings above 70 or below 30 are very strong indications of a market reversal. (See Fig. 6.3 and Fig. 6.4)" 

(5) Divergence: Although divergence does not occur at every turning point, it does occur at most significant turning points. When divergence begins to show up after a good directional move, this is a very strong indication that a turning point is near. Divergence is the single most indicative characteristic of the Relative Strength Index."

RSI indicator Formula

RSI = 100 - 100 / (RS + 1)
RS = Average Upward Price Change / Average Downward Price Change

Average Upward Price Change = [(previous Average Upward Price Change) x 13 + current Upward Change] / 14

First Average Upward Change = Total of Upward Changes during past 14 periods / 14

Average Downward Price Change = [(previous Average Downward Price Change) x 13 + current Downward Change] / 14

First Average Downward Change = Total of Upward Changes during past 14 periods / 14

For calculation Downward Price Changes are taken as positive values.


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