6. Get Top Trading Signals with the RSI

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1 INTERMEDIATE 6. Get Top Trading Signals with the RSI The Relative Strength Index, or RSI, is one of the most popular momentum indicators in technical analysis. The RSI is an oscillator that moves between the values of 0 to 100, helping to signal overbought and oversold conditions in the price. The RSI is useful across a number of time horizons. The basic premise is that the RSI looks at the number of days in a given time period where the price is up, compared to the number of days the price is down. The formula then calculates where the price is trading relative to the action over the period in question. In the original study, the inventor of the RSI, Welles Wilder used 14 periods as the optimum number to use. This means that on the daily chart, you use the 14 day RSI; and on the hourly chart you would use the 14 hour RSI. However, the parameters can be adjusted to meet the needs of the user. Shorter-term traders may like to use fewer periods when calculating the RSI, with the 9 period RSI often a popular calculation. Reducing the number of periods in the calculation will result in increased volatility and more signals, with quicker moves into the overbought/oversold territories. However, the downside of this is that there is an increased propensity for false signals. Calculation Using an adaptation from the original Welles Wilder formula, the RSI can be calculated as: RSI = RS where RS = The average gain over the number of periods The average loss over the number of periods The formula calculates a number in a range between 0 and 100. Broadly speaking a reading above 70 is used to suggest that the price is overbought, while a reading below 30 is used to suggest that it is oversold. 1

2 6. Bollinger Bands Figure 1: The 14 day RSI on EUR/USD N.B. Do not confuse the RSI with the Relative Strength Ratio One of the reasons why the RSI is known by its acronym is to avoid confusion with the Relative Strength Ratio, which is an indicator that measures the performance of one instrument relative to another. In Figure 1, Euro/Dollar is a highly liquid forex pair and the limit of 70 is rarely breached on the RSI. Therefore when the RSI moves above 70 this tends to be a very good indication that the momentum has become stretched and the chances of a trend reversal setting in are high. The RSI helps to identify whether the price has been unreasonably pushed to current levels and whether a reversal may be on the way. Reading the RSI If the RSI is above the 50 level and advancing, momentum over the period being studied is considered to be positive. Conversely, if the RSI is below 50 and in decline, momentum over the period being studied is considered to be negative. In his original work, Wilder found that the instrument became overbought when the RSI went above 70 and became oversold when the RSI fell below 30. The RSI can therefore help to identify signs of exhaustion in a trend. However, exactly how you analyse the RSI will depend on whether the price is trading in a strongly trending market (either up or down) or whether it is in a ranging market. Trading the RSI in a trending market It is also worth noting that in a trending market the RSI can remain stretched for an extended period. By the way the RSI is calculated, in a strong trend, there will often be sustained periods of positive trading days. Subsequently, the more up days that are seen in the calculation period, by definition, the RSI can sustain a move above 70. It can therefore be a gauge of the strength of the trend and not always a sign of a reversal. The opposite can often be seen in a strong downtrend. Figure 2: Trading the RSI in a trending market on GBP/USD Therefore best way to trade with the RSI in a trending market is to trade in the direction of the trend. In a strong uptrend the RSI will often use the 50 level (or sometimes between 40 and 50) as the limit of the downside before the buying pressure resumes. This would be used as a chance to buy. Looking for bearish divergences (explained below) can be a signal to take profit on long positions. It is unadvisable to go short in a strong uptrend. 2

3 Trading the RSI in a ranging market The classic use of the RSI is as part of a mean reversion study. Traders can use the oversold 30 level to buy (or close short positions) and the overbought 70 level to sell short (or close long positions). Figure 3: Trading the RSI in a ranging market on USD/JPY Using RSI to generate trading signals 1 Crossover signals A crossover is a buy or sell signal that is generated when the RSI moves to an extreme level and then begins to retrace the move. The crossover uses the levels that Welles Wilder deemed to be overstretched, with 30 considered oversold and 70 considered overbought. RSI crossover signals will work much better in a ranging market, because in a strongly trending market the RSI can fluctuate around overbought/oversold for some time before a reversal takes hold. In ranging markets, RSI crossovers and divergences (see later) can be the trigger signals. The crossover buy signal is generated by a sell-off that takes the RSI below 30 and then a recovery sees the RSI cross back above 30, with the signal generated as the prices crosses back above 30. The crossover sell signal is generated when a strong move higher in the price pushes the RSI above 70 and into overbought territory, only to be followed by a correction which results in the RSI crossing back below 70, which is the sell signal. Figure 4: RSI crossover signals on GBP/USD 3

4 2 Bullish and Bearish Divergences Traders will also look for divergences on the RSI as further indication of a trend reversal. In a bull market, if new highs are posted on the price at the same time that the RSI is in decline, this suggests that the strength of the upside momentum is waning. This is a Bearish Divergence and implies that there is an increased likelihood of a reversal in the price. A Bullish Divergence is the opposite and is seen in a bear market, where there are new lows on the price which are accompanied by higher lows on the RSI. The caveat for trading divergences comes with the fact that a divergence between the price and the RSI can continue for some time before a reversal sets in. 3 Failure swings A failure swing can occur in both an uptrend and a downtrend. In a bull market, a failure swing is a sell signal. It forms where the RSI moves into an extreme position above 70, only to then pull back below 70. The RSI then resumes a move higher only to create a second peak which is at or below the previous peak. The failure swing is then complete on a move back below the first low. The RSI takes the form of an M shaped pattern. In a bear market, a failure swing is formed where the RSI moves into an extreme position below 30, with a rally causing a low in the RSI and pulling it back above 30. The selling pressure resumes and drags the RSI back below 30, to create a second low either at or above the previous low. A failure swing is then completed as an improvement in the RSI pulls it back above the previous reaction high, thus forming a W shaped pattern. The best triggers are seen with a combination of the signals. For example, a bearish divergence with a failure swing is a powerful sell signal. Figure 5: An RSI bearish divergence with a failure swing on Euro/Dollar N.B. As with all of our indicators we recommend against trading with indicators in isolation. We would always look for confirmation signals in other studies to improve the conviction of our analysis. 4

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