As a trader, you should be familiar with the different technical indicators that are used in trading. Now technical analysis studies the past price action to predict the future price action. Technical indicators are an integral part of understanding the price action that is taking place in the market. Relative Strength Index is a highly popular technical indicator and widely used by the traders to trade different markets. Relative Strength Index (RSI) is a type of momentum oscillator. You must know what momentum means from your high school physics. RSI is a momentum indicator because it RSI follows the uptrend or the downtrend in the security prices. Now why RSI is considered to be an oscillator because RSI always fluctuates between 0 and 100%! Another feature of RSI that is considered to be very important by the traders is its levels that indicate when a security or a currency pair is considered to be overbought or oversold. When a security reaches one of these levels, an experienced trader always gets ready for a change in the RSI trend.
Most of the technical indicators are lagging. What lagging means is that they follow the price action! RSI indicator is also considered to be lagging as it compares the strength of the security or the currency pair on its up days with its down days and this way an RSI indicator can cut through the erratic changes and really confirm price movement. In some ways, it is also considered to be a leading indicator as you can count on an RSI indicator to change ahead of a currency pair’s or a security’s price action.
Another intriguing concept is the overbought and oversold levels. Most of the time you will hear the security or the currency pair being overbought or oversold! 30 on RSI is considered to be an oversold level and 70 as an overbought level. How do you know that the security or the currency pair is overbought or oversold at these levels? These overbought and oversold levels were introduced by a famous Technician J. Welles Wilder who had introduced the RSI indicator in his book, “New Concepts in Technical Trading Systems”. These are just relative numbers. Keep 30 and 70 in your mind and when these two levels are penetrated look for confirmation from other indicators.
Now Wilder in his book quoted above had recommended these levels. The oversold level of 30 and the overbought level of 70 are indicated as lines on the bottom of the chart to let you see when these two levels are crossed by the RSI. So when you see one of these levels penetrated, time to get on your toes and get confirmation from another indicator. Wilder also suggested to use 14 as the standard number of price periods for calculating the RSI.
Calculating an RSI on your own with a spreadsheet is fairly complex. If you try to calculate the RSI indicator you may take a few pages! You just need to know this the RSI indicator takes the up and down days and plugs that data into a fairly complex formula to come up with a percentage number between 0 and 100. However RSI is very easy to use in practice. It is shown on the bottom of the chart as a slow moving line. By comparing this slow moving line at the bottom of the chart with the main candlestick chart in the upper part of the chart, you can understand what is happening to the price action.
Most of the time RSI will try to follow and mirror the movements of the price action in the top part of the chart. However, sometimes RSI will flatten while the price continues to move or even move in the opposite direction. When it does so, this change is known as Divergence. Divergences are the key to using RSI. Divergence is the most powerful tool in trading. More on the divergences in a later post!
As said earlier, you cannot simply use an RSI to buy when it hits 30 or selling when it hits 70. It is always good to combine the RSI with candlestick patterns or a divergence in RSI. So you have to combine it with other indicators to give more reliable buy and sell signals.
Hassam 