What is an RSI Indicator?
The RSI indicator or Relative Strength Index is found on nearly every technical trading platform. It is in the group of the indicators often referred to as oscillators because it isn’t directly charted against the price like a moving average but sits in a separate window with its own abstract scale, rising and falling in response to the momentum changes on the price chart. The momentum changes are over a given time period determine the RSI value and most trading packages will allow traders to edit this timeframe. The RSI also has a fixed scale from 0 to a 100 and an equilibrium point of 50. It doesn’t matter whether the equity is at five dollars, fifty dollars or five hundred dollars if the price stays steady the RSI will sit at 50. The RSI like most indicators is a lagging indicator as it rates the current price behavior against its historical data.
Even if an equity’s change in value is constant its RSI will also tend to towards its equilibrium level of 50. This is because it isn’t the change in value the RSI reacts to but the rate of that change. This means a movement of a few cents could cause the RSI to change value dramatically if an equity has been sitting at the same price for weeks while a fluctuation of a few dollars may have little impact on the RSI of an equity that has been growing steadily in value.
The extremes of the RSI at 0 and 100 are seldom if ever reached as the effort required to move another point further from the 50 level grows exponentially. So many traders set up overbought and oversold signals at 70 and 30 respectively. This is taken to mean that if the RSI gets above 70 or below 30 the price is very likely to reverse to relieve some pressure. Using the RSI to indicate overbought and oversold points on the chart is the most commonly recommended use of the RSI. As such it would be used to indicate when to take profits or perhaps try to counter trade the prevailing trend. However using the Overbought and oversold indications as entry points in highly volatile markets is very risky and very likely to cause more losses than gains.
RSI a Trend indicator
What isn’t discussed in most trading manuals is the power of the RSI to be used as a tool to determine the direction and strength of a trend. Simply by adding a line at the 50 level the RSI becomes an indicator of the direction of the trend. Often when the new trend forms the price will move rapidly higher or lower causing the RSI to breach the 70 level in an emerging uptrend or the 30 level in an emerging downtrend. After doing this the RSI will retreat to the 50 level as the initial thrust loses momentum. However the price often meets resistance or support at this 50 level and turns back in the direction of the new trend. People who saw the breach of the 70 or 30 levels as a chance to trade the reversal will usually be caught out. As the trend strengthens the RSI will oscillate between the 50 and the 70 in an uptrend or the 50 and 30 in a downtrend. As it weakens the RSI will increasingly cross the 50.
Another strong indicator of trend is to place a Moving Average on the RSI. The RSI crossing this average can be more pre-emptive than waiting for the price to cross a moving average on the price chart. In other words it can give the trader opportunity to enter a trade earlier than the normal moving average would indicate and also help eliminate some of the false starts experienced by trading RSI countertrend signals too early.
While the RSI indicator can be used to pick entry points and opportunities to take profit, the setting of stops should always be based on the price chart. As an oscillator the RSI’s movements are abstracted from the price behavior and are distorted, small movements in the RSI may be the result of a big movement on the price chart or a big movement in the RSI could result from a relatively small price move. For best results the RSI should be coupled with other indicators particularly price chart based indicators like moving averages and Bollinger bands.
In the example above the EURUSD currency pair has been trending down over some
time. The initial downward thrust causes the 14 period RSI to cross below the
30 period as highlighted by the green circle. The price moves upwards and when
the RSI is at around 50 begins a long and sustained decline. Shorting at this
red circle would prove a profitable trade. During the decline the RSI oscillates
above and below the 30 level many times giving false signals that the currency
is oversold. As the main decline weakens the RSI moves back to the 50 and again
provides an opportunity to enter in the direction of the trend as it dips below
the 50 level. This occurs twice.
Convergence-Divergence
The RSI’s more frequent crossing of the 50 level towards the right side of the chart indicates the downtrend is weakening and probably over. The yellow lines are to show another strong signal in the RSI chart called a convergence-divergence. In this example the price chart is making lower lows but the RSI’s corresponding lows are getting higher. During an uptrend a convergence-divergence would be where the price is making higher highs while the RSI’s corresponding highs are getting lower. A convergence-divergence is a classic indication that the trend preceding trend is over and the price is reversing.
