- August 3, 2017
- Posted by: CoachShane
- Categories: Advanced Trading Strategies, Trading Article
One of the most popular technical indicators has to be the relative strength index (RSI) which was developed by J Welles Wilder.
I didn’t just make that up as I read a survey done with users of the Bloomberg Professional Terminal and the RSI was the top ranked trading indicator used on that platform.
You could toss a dart at any RSI indicator trading strategy and what is being measured is the momentum in that market.
The name “relative strength” may lead some to believe you are comparing two markets but the RSI simply compares your market of choice to itself.
The RSI compares the strength of up days to the strength of down days and with that calculation, we can determine if the momentum taking place is either bullish or bearish (consider lack of momentum as well).
RSI and Welles Wilder
1978 saw an article published in Commodities Magazine by Welles Wilder where the Relative Strength Index was introduced to the public. It was followed up in a book by Wilder called New Concepts In Technical Trading Systems.
Its a bounded momentum oscillator that fluctuates between a top level of 100 and a bottom level of 0 which allows traders to use it as an overbought and oversold indicator. The popular settings to measure the OB/OS of an instrument are:
- 80/20 where 80 is overbought and 20 is oversold
- 70/30 where 70 is overbought and 30 is oversold
The RSI oscillates using a calculation that compares the relative strength of gains in price of days that close above previous days close (up days) to the price loss on days that close below previous days close (down days). RSI Calculation = (100 – (100 / (1 + U/D))
To aid in that calculation, Wilder suggested a look back period indicator setting of 14 periods be used. Like virtually every trading indicator, you can tweak look backs and even the oversold and overbought levels but there is no magic setting that is going to produce a “holy grail” in terms of trading success.
If you do decide to tweak the default settings of the Relative Strength Index, try to line up RSI turning points at the 80/20 or 70/30 lines with the turns in the market.
A longer look back will ease off on the volatility of the RSI where a shorter look back will see more volatility in the indicator.
The bottom line is we are using the relative strength indicator to “indicate” the strength in the market as well as the potential for a turn in the market for any trading strategy.
Trading Oversold And Overbought Levels
Wilder did consider oversold and overbought but not in the same way as it is used today which is reversal points. For Wilder, either market state would actually prompt a trade in that direction.
- Overbought markets would be candidates for long trades and buy signals
- Oversold markets would be candidates for short trades and sell signals
For this trading article, we will look at the more conventional method which is using these zones for reversal trades. I am using a look back period of 14 and the oversold and overbought levels are 30/70.
This is the weekly chart of the USDCAD Forex pair and there are 4 areas that have been highlighted:
- After a long run, RSI becomes overbought and price movement begins to consolidate and retrace which works off that overbought condition
- A 6 month run occurs and we hit overbought once again and this time we get a small retrace in price.
- Price runs again and we have another overbought condition and we get a one week bearish engulfing candlestick that finally turns price
- Price has broken out of a channel and after a few weeks of free fall, oversold condition occurs on the Relative Strength Index and we see signs of a weekly reversal
Note that 2 overbought conditions did not change the overall trend of the market. If you were to short on the basis of overbought and believed a downtrend was coming because price had run “too far”, you got hurt.
Price action on the third overbought condition was the telltale sign that the odds were favoring a fall.
Blindly trading OS/OB levels as indicated by the RSI is not a fully developed trading plan or trading strategy. Including price action and an oversold or overbought condition on the Relative Strength Index is a more refined approach.
Remember, RSI measures momentum and an instrument with continuing strong momentum will eventually roll over. The issue is markets can stay at oversold overbought levels longer than you can keep being a contrarian trader. These levels do not always lead to a trend reversal.
I have plotted on a Keltner Channel to highlight the point that a strong market that becomes overbought (or oversold) can stay that way for a long time. This Keltner Channel is using 2 standard deviations and, being a weekly chart, blindly shorting the upper band or the overbought Relative Strength Index would have been painful.
Wait until price action confirms a directional change in the market.
This was the first introduction to the RSI back in 1978. Quite simply, we are looking for the indicator to diverge from price.
- If the market is in an uptrend, we are comparing highs in price to the highs in the RSI
- If in a downtrend, we compare the lows
This chart is in a uptrend in price and the RSI plots the instrument into the overbought area. We know we don’t simply take a short position until we have something to short against. Think of having a confluence of factors coming into play to support the trade.
Price puts in a high at #1 in both price and on the indicator.
At #2, we have bearish divergence. Price has pushed to a new high yet the RSI plots a lower high.
Is there a shorting opportunity?
- Price puts in a high while we are indicating an overbought condition
- Price puts in a higher price high but a lower RSI high and has left the OB zone
- Price has breached a potential resistance area
- Reversal candle indicating a failure test of the high
After price travels down, the RSI pokes into oversold at #3 and exits on the next candle. This can have you on alert for a long trade but we need something else to back us in the trade.
Ranging price action ends with a push down to the top of the OS area at #4. Price breaks the previous swing low but the RSI puts in a higher high which indicates bullish divergence as price makes a lower low but the momentum indicator puts in a higher low.
You can simply reverse what we saw in the shorting opportunity to give you a potential trade to the upside
This is a perfect example of divergence using the RSI. There are times where you will get divergence but price does not react the way the textbooks suggest. It is important to have supporting variables to your trading and that is where knowledge of structure and price action will serve you very well.
RSI Failure Swings
This is an interesting use of the relative strength indicator and may appeal to some traders. We are looking for the RSI to fail to surpass a previous high or low and then surpasses a former peak/trough. Think of it as support and resistance failing or holding on the RSI instead of price.
- RSI hits overbought, exits the OB zone, puts in a lower swing high and the trade is when the RSI breaks the low as outlined with the black line
- We drop into OS and remain there for a while. RSI exits and there is a small swing that plots and the trade is at the break of the high
- OB zone is exited and RSI puts in a lower swing high. Trade is at the break of the low as indicated
The first trade has you short and you will sit through some sideways price action. Given the momentum move down and then lack of immediate follow-through, this could frustrate many traders.
The second trade works right from the outset in that there is direct action in your favor. Proper trade management would be vital especially since price was in a down trend when you entered.
Third trade would be extremely painful to sit through. You enter in a range and even when it eventually breaks, price exhibits a strong rally back to the same zone.
You may want to do extensive testing on this type of trading. Even from this brief example, you can imagine the host of issues that could crop up that may be avoided if you were tuned into price action and important structures
RSI Support and Resistance
Traders will also use the RSI as a means to find support and resistance levels that may not be evident on the trading chart. There is no difference with how you draw your lines as you would do it the same way as the price chart. Either horizontal lines are used as well as using a trend line by itself or to help form a trend channel.
Using this chart, refer to the arrows on the RSI and follow up to the price. The one I find the most interesting is the highest peak and where the RSI showed potential resistance at that point. I much prefer using this RSI technique with channels as shown on the right side.
While this technique may have merit, my preference would be to refer to price for support and resistance as opposed to a derivative of price calculation.
Determine Trend Direction With RSI 50
The period length of the RSI will greatly affect this reading however if the RSI is above 50, many traders would consider the market bullish.
Below 50 would indicate bearish price momentum.
The main issue I have with this is that even in a strong uptrend, price will still retrace enough to push below 50. To add to that problem, in a bull market, pullbacks in price can often be seen finding support at an RSI reading of 35-40.
In a down trend, RSI can hit 60-65, find resistance, and not violate the determination of a down trend.
As you can easily see, there is not much in trading that is cut and dry
Look through the various RSI conditions and compare them to price on this chart. You can easily see why using price action along with any trading indicator including the RSI is a better idea than just taking indicator trading signals.
Relative Strength Index and Chart Patterns
Much like the support and resistance technique, using price action is the preferred way however there are trades that use RSI for chart pattern identification.
I’m not going to show examples of this as chart patterns are highly subjective but patterns such as head and shoulders may be found in the RSI window.
RSI Trading Wrap-Up
The relative strength index is quite the versatile technical trading indicator and the simplicity and apparent robustness can be intriguing for further testing if you found interest.
Perhaps there is merit to slightly optimizing so the OS/OB of the indicator lines us with recent swings in the market. This would probably be something you’d want to do on the higher time frame charts (daily, weekly) as intra-day has many more swings to contend with.
There are other popular look back periods on the RSI such as 9 and 25 but again, this is something you’d want to test before implementing it in your trading. Technical analysis is not an exact science and you will never find the perfect indicator setting.
The biggest takeaway is to make sure that you have fully tested your trading plan when using the relative strength index trading indicator. It’s a lot of work but without testing, you will never fully trust your trading strategy and will never allow it to reach it’s full potential.