Trading with the Relative Strength Index (RSI)
Standard indicators, like the Relative Strength Index, are valuable tools in trading. They allow to measure and quantify price movements. The RSI puts a closing price in relation to the prices in the past to indicate how strong the last price is in a series of prices.
The Basics of the Relative Strength Index
The Relative Strength Index (RSI) is another standard indicator from the group of oscillators. As we explained in our previous post about the Fisher Transform Oscillator, this group contains indicators that oscillate around a neutral value. This indicator, like other from Momentum Oscillators group, measures some kind of velocity of price movement in the markets. The concept is easy - in a strong movement - for example up - a weakness may trigger a correction because the market is what is considered overbought. Many have purchased hoping for rising prices and a small stop or correction in movement may trigger a small wave of short term exits.
The Relative Strength Index Formula
From mathematical point of view Relative Strength Index (RSI) is equal to: 100 - 100 / (1 + Relative Strength) where Relative Strength is a ratio of average based on up price change divided by period and average based on down price change divided by period. The Relative Strength Index (RSI) give values between 0 and 100. The typical settings for the Relative Strength Index is a period of 14 for both averages. The original usage - like for most standard indicators - was on a daily chart taking nearly 3 trading weeks (of 5 days) of data into account. Today the Relative Strength Index is used also with others time frames. Like with all indicators computers make it feasible to perform calculations on every tick.
Trading with the Relative Strength Index
Like any indicator using, using the Relative Strength Index is not as simple as just dropping it onto a chart. The typical usage is to identify an overbought or oversold situation, trading against weakness in a trend and hoping for a correction. We will look at simple strategy to make a concept of this indicator more understandable. Most common is to read a value above 70 of this indicator as an overbought state of market. Below 30 it will be an oversold state.
Taking into consideration, simple strategy may establish a long position when the Relative Strength Index (RSI) value first is below 30 and then crosses above this level.
Similar, a short will be in a place when indicator first is above 70 and then falls below this level.
A weakness of this approach is obviously - like with nearly all indicators - that the Relative Strength Index looks at a fixed number of historical data, not taking obvious reversal points into account.
Relative Strength Index can also be used as a warning signal when it shows a divergence. A Divergences is a discrepancy between the indicator and either other indicators or the price in itself. For example, a warning can be raised (indicating a possible change in price direction) when the indicator shows an overbought or oversold indication, and the price fails to follow through (with a new high or new low). The Relative Strength Index can also be used to indicate support and resistance based o peaks made by the indicator. J. Welles Wilder, Jr. claim that support and resistance level are most often visible faster on the index before becoming visible on the bar chart.
Another possible use of the Relative Strength Index is the recognition of swing failures, which can be an indication about reversals. When previous high is not exceeded on a small upward trend, and this happens when the Relative Strength Index is above 70, this may indicate a reversal from bullish to bearish, and as such a change in the major price direction. The same obviously is true on a bearish trend, where the failure to achieve a new low, with the Relative Strength Index in oversold territory, can indicate a reversal to a bullish trend.
This is particularly useful (or: only useful) when one combines the Relative Strength Index with other indicators or standard price action filters or pattern recognition, for example to use it in combination with an algorithm that is identifying a head and shoulder chart pattern.
Weak points of the Relative Strength Index
The Relative Strength Index often makes little sense in a strong trending market. In this type of market is common that overbought or oversold indication presented by the RSI are not trustworthy. Don’t be surprise when your Relative Strength Index (RSI) shows overbought state and market continue his bear trend for next bars. This is the typical "long tail" problem that many mathematical indicators have.
The Relative Strength Index - useful if one is aware of the limitations
Properly used the Relative Strength Index can be a very valuable tool. Especially to analyze a change in the movement direction. When used in combination with classical chart reading, the Relative Strength Index is providing new ways of interpretation of market behavior. There is no indicator without flaws. Here at trade robots we are using indicators with awareness of their advantages and disadvantages. Simply said: no single indicator is producing correct signals all the time, and a programmer has to be very aware of edge cases and the underlying concept of an indicator to make it work. A successful trade comes from decision based on interpretation of different indications combined together.