Relative Strength Index
The relative strength index is a very popular indicator, invented by Wilder about three decades ago (1978 to be exact). The RSI indicator serves to warn when a market has been overbought (i.e. risen too much) or is oversold and the technique is valid for any market including stocks, forex pairs and commodities. The ‘relative’ in the name is referring to the stock or security being reviewed, not as more usually in trading circles, to similar stocks or an index in the same sector. That is, the RSI compares the stock’s performance to itself.
But what is the RSI? In essence it consists of simple support and resistance lines. The Relative Strength Index tells you when a market instrument has been overbought or oversold and in this respect the indicator tries to identify when the trend is likely to turn around and change direction.
The formula actually compares the stock’s performance over the past number of days (typically 14 periods), and looks at the average up days and down days closing prices. It gives you a measure of the momentum of the market in either direction. By using averages Wilder’s formula smooths out the possible variations that you can get when you compare only individual days, such as with some oscillators described earlier. The value is also normalized to a range from 0 to 100, and the standard boundary lines are drawn at 30% and 70%.
The example above is based on 14 days, which is one of the standard periods used. If you use a lower number, the indicator becomes more sensitive and swings more widely. You can use a greater number of days for more smoothing and a less dramatic profile. The 30% and 70% boundary lines are usually considered about right when you use 14 days. When the RSI drops to 30 or below the market is said to be oversold, while at value of 70 or higher, the market is said to be overbought.
So how can you utilise the RSI? One way is to look for signals when the RSI moves out of oversold or overbought territory. In the case of the former scenario, when the RSI indicator crosses above 30 a buy (or cover) signal is generated. In case of the latter, a sell (or short) signal is triggered when the RSI crosses below 70
However, Wilder pointed out that you cannot assume that you should trade when the indicator exceeds the 70% line or goes below the 30% line. In fact, quite often you will see the RSI go to the extreme while the trend is still strong, and it would be mistake to exit a long position or enter a short position thinking that an uptrend was about to change on the basis of an overbought indication. You can see a couple of examples of this in an uptrend in September/October in the chart above, and on the right of the chart there is prolonged activity below 30% before the downtrend reverses.
Divergences between the Relative Strength Index and the price can also provide warning of a future price reversal. Similar to price action, the Relative Strength Index is constantly moving up and down in a zigzag pattern which makes identifying divergences relatively straightforward. When the price make a series of lower lows it might be the case that the RSI would be doing the exact opposite (making higher lows – sometimes referred to as bullish divergence). This divergence is an indication that the price momentum is changing and spread traders would do well to be looking for a change in trend. The reverse is of course also true in an uptrend (bearish divergence); the Relative Strength Index here starts making lower highs as the price keep making higher highs, implying the rally may be losing momentum. There could also be a case of positive divergence if the RSI makes a lower low while the price marks a higher low as it is comes out of a downtrend which is a bullish signal. Lastly, a negative divergence can materialize if the Relative Strength Index makes a higher high while the price hits a lower low in an uptrend which is essentially a bearish signal.
Sometimes these reactions have what Wilder used to call failure swings and this highlights another use of the RSI. Failure swings are independent of price action and happen at the crossover oversold (30) and overbought (70) zones. A failure swing occurs when a peak above 70% fails to exceed a previous peak in the uptrend, but then breaks downwards below the level of the trough between. Looking in October on the chart, there are a couple of incursions above the 70% line, then one that is not as high as them around the middle of the month. This is a ‘top failure swing’, and when the indicator comes down below the trough in-between the peaks, this is a signal that the trend is reversing. Again, from the chart, it is only at this point that the price actually peaks and starts falling.
‘Adding an Relative Strength Index indicator will allow you to range trade between the overbought and oversold levels in a technique that is very similar to looking for areas of support or resistance.’
Just to make that clearer, here’s an enlargement of that part of the chart.
You can see the first peak, which is on a high volume, but it should not be considered enough to enter a trade. The RSI swings down to form the trough, but then comes back up to top failure swing at a lower level than the first peak.
Having failed to exceed the previous peak, the pattern is completed when the RSI drops below the trough level, as noted, which is when you would consider the trade. I’ve drawn a red line up to the price chart, which confirms that there was a fake move previously, but this would have been a good time to initiate a short position.
In a bullish failure swing the Relative Strength Index crosses over 30, but then pulls back to just above 30, finally moving higher – pushing past the last peak high of the RSI in a breakout.
This emphasizes the point that when using an indicator, you should always keep an eye on the trend. If the indicator is moving in the opposite direction to the trend, as it did when it formed the trough, this is a ‘watch out’ moment which tells you that something may happen shortly.
Constance Brown made a modification to the Relative Strength Index in 1999; instead of using the usual values of 30/70 to indicate oversold and overbought levels she looked at 40/90 as reversal thresholds for a bullish market and 10/60 in a bearish market.
Like most momentum oscillators, the RSI indicator works best when prices are sideways moving inside a range. Sideways markets can be identified when looking at short-term moving averages, like 5 or 10-day simple moving averages – should these flatline or return numerous crossovers in a short timespan. In situations when trending methods don’t work, momentum indicators tend to perform well.
Is an RSI of over 70 a good enough reason to sell? No. If RSI is very high it could be that the market is very strong, and will continue higher. RSI has little predictive value at all. If your market is trapped in a trading range a high RSI reading would be something to pay attention to, but you could just as easily sell at the top of the trading range. The key question to ask is always “are we trending or in a range?” And if you can’t tell you are probably in a range. In a range traded environment try and sell near the top of the range (a quick scalp), and in a trending environment, try and hold for as much of the move as you can get, trailing a stop.
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