The Relative Strength Index: How to use reversion in order to conquer the trend

Initially mentioned in an article in Futures magazine, the Relative Strength Index was invented by J.Welles Wilder, and ever since, it has turn out to be one of the more popular price momentum indicators and a pillar of technical analysis, offered in almost every charting package.

Welles Wilder came up with RSI to identify overbought and oversold conditions, and the indicator is built to measure average up-move against average down-move.

Relative strength is visualized on a vertical scale from 0 to 100.

A measure over 70 indicates overbought and a reading under 30 means oversold.

While weighted moving average is normally used to calculate those values, different versions occasionally use an exponential moving average.

The indicator presumes that overbought levels tend to happen after the market has advanced for a disproportionate number of bars, and that oversold levels normally emerge after a significant number of declining bars.

Sounds impressive, right?

Think about it this way.

The Relative Strength Index (RSI) is actually measuring the strength of a trend in order to ascertain when it has arrived at a peak or trough and thus is ready to reverse.

This indicator is used widely by technical traders in all financial markets.

Some inventive traders have taken the RSI far beyond its original intent, and use it as a primary trading tool on par with the price action itself.

Others use this indicator as a key confirmation tool on the bottom of their charts.

Filtering out erratic price movements

The RSI value is determined by comparing an average of the up closes to the down closes during specific period.

There is only one variable, which is the number of periods (e.g., hours, days, or weeks).

The common RSI preset value for length is usually either 9 or 14.

The value of relative strength indicator is determined using only the number of closes. That number is defined as the length setting and values 9 or 14 are used only as a matter of convention.

The most commonly used default value to represent an oversold condition is 30 and below and 70 and above suggests an overbought reading.

Does this sound familiar?

Well, the RSI has nothing to do with the concept of Relative Strength, which compares the price of one financial instrument with another.

For example, the manufacturing group compared to the S&P 500 Index.

Let me explain.

Wider took a somewhat different approach in that he compared an instrument against "itself."

The addresses two issues:

Firstly, it smoothes out erratic price movements, which is a common problem found with any moving average.

And second, it maintains the oscillator in a constant range between 0 and 100.

Avoid this common overbought or oversold misconception

Once either level has been breached, we have to think of the market as actually being overbought or oversold.

That is the moment when a warning flag goes up.

We are not talking about sell or buy signals yet.

There is a big difference.

Consider the underlying logic.

As the forces of supply and demand counteract each other and push an instrument to an overbought level, we don't want to sell it just yet.

The reason it's overbought is because there is still a great deal of power in the instrument, and that power can last longer than we can anticipate.

Therefore, don't jump on it just yet.

Let your other indicators guide you to a short position.

On the other hand, buying just because it is oversold is not the most intelligent thing in the world.

One of the reasons something is oversold may be because nobody wants it.

Momentum – key to predicting price movements

When attempting to find the right time to buy or sell an instrument such as a stock or currency pair, it is important to try and predict future movement.

One of the more important aspects of this is judgment of momentum – how strongly the market is trending.

While strong move in a particular direction can indicate a likely trend, it can also show that the instrument is overbought or oversold.

RSI is one of the key indicators that technical traders use to measure momentum.

Let see exactly how this works:

Basically, RSI measures price momentum.

It relies exclusively on the changes in closing prices, and as such the RSI is actually a front-weighted price velocity ratio for only one instrument.

To conform with the standard interpretation of the price velocity indicators, a considerable emphasis is placed on confirmations and divergences of RSI compared to the underlying price series.

RSI's is calculated using Exponential Moving Averages and therefore accurately avoids the problem of erratic movement attributable to dropping off old data, that plagues some of the more popular indicators as Stochastics, Rate of Change and short Simple Moving Averages.

Looking out for warning signs of trend exhaustion

The Relative Strength Index is represented as a value ranging between 0 and 100.

Values above 50 signal upwards momentum, while values below 50 mean that the momentum is downwards.

The farther the distance from 50, the stronger the momentum.

Values above 70 or below 30 suggest that momentum is so strong that the market is overbought or oversold.

At these levels, one should start to wonder whether the trend is sustainable and look for warning signals.

An important measure of internal strength

Have you wondered why you have to wait for the momentum indicator line to cross the zero line instead of making the buy/sell decision when it changes direction — just after an indicator top or a bottom?

J. Welles Wilder, Jr. answered this question.

He suggested to make the buying decision at the change of direction only after the average up move is greater than the average down move over a certain period (or the other way around for a sell signal).

In other words, as the name relative strength suggests, the average momentum is relatively higher (or lower).

Let’s look at it in detail:

In currency market the RSI compares the strength of the currency pair to its own price history, measuring the internal strength.

Looking for a divergence between the price making a new high and the indicator’s failure to violate out its own previous high is popular way of analyzing the RSI.

This divergence is construed as a signal of a likely reversal.

As an indicator it places heavier importance on most recent price data and as such is extremely widespread among currency traders who use it in a variety of ways.

Because it features built-in smoothing functions, the RSI successfully filters out the noise generated by price spikes.

The readings above 70 and below 30 are considered to be similar to volume spikes seen in forex markets and, depending on the immediate price action that follow those readings, one can either traded them as trend-based volume breakouts or fade them as indications of price exhaustion.

More insight into the notion of overbought and oversold

The meaning of the terms "overbought" and "oversold" is relative to market conditions and the volatility of a particular instrument.

For instance, when the price is in a powerful uptrend, levels above 70 (overbought) can trigger numerous times prior to the trend actually changing direction.

The same holds true for oversold signals.

It's important to understand something that is overbought can always get even more overbought, and one that is oversold can always get even more oversold.

The terms ''overbought'' and ''oversold'' are conditions, and not signals in and of themselves.

The price can rise to an overbought level, and then simply continue rising for quite some time.

And you know what?

If you are going to go short simply because of an overbought reading, you may find yourself on the wrong side of a trend.

As a result, in most cases, we consider the first touch of the 70 or 30 levels during major trends, either up or down, to be less significant.

The other issue is that the RSI provides no guidance on exiting a position based on such a signal.

While an extreme RSI reading is generally consistent with a strong trend, a cross of back into neutral territory is more likely to represent a resumption of the existing trend than the establishment of a new one.

Subsequently, there may be a point at which an exit signal is triggered.

Rather, the RSI tends to stay for long periods in neutral territory.

Thus, some additional tool, such as another technical study or money-management rules (stop-losses), must be used with the RSI.

Divergence patterns in RSI

The default setting for the RSI normally uses 14 periods, weighting the value of more recent data by employing the exponential averages for up days and down days to calculate final results.

One of the more common methods of trading it is by uncovering divergence patterns.

If price continues to make new highs but the indicator does not, then one must be on alert for a likely trend reversal or trend consolidation.

Because the RSI so good at smoothing price action, some traders go as far as trading patterns off the RSI itself rather than off price action.

What makes this so special?

Because short term price action, can be highly volatile and unpredictable, it will often trigger multiple false signals.

The RSI, in contrast, smooths out the price action and provides more clear picture of actual price direction.

One intriguing way to trade the RSI is as a proxy for the volume in currency market.

Fading short-term spikes in forex

Want to see how it works right now?

Here is how RSI can be used to fade short-term spikes in the FX market.

On 1 hour chart look for levels of RSI 70 or higher or RSI 30 or lower, making sure that this reading occurs during the currency pair's active hours.

Once the highs or lows of the session are set and the RSI signals retreats from its oversold or overbought levels, moving off its extremes, and the active session hours are over, the trader would then measure the full range of the active session.

If the price rallied during the active session, then the trader would set a sell zone at the top 20 percent of that day's range and further set a stop at 20 percent above the high of the range.

If the price tries to retest the highs, one would short the move.

Once the profit target is reached the half of the position could be covered and the stop will be moved to break even.

Conclusion

In market contexts where very steep rises or declines are present, RSI is useful in alerting you to a potentially volatile or high-risk situation.

At the very least, RSI numbers under 30 and over 70 caution you of the potential high risk or unfavorable risk-to-reward balance in entering into new positions.

If you already in a position, such extremes may be the reason to tighten stops or take partial profits.

While it is considered risky, traders often initiate short-term trades that probe the short side in an overbought context or the long side in an oversold environment.

While RSI readings are in this normal zone, it is of less practical use for trading.

The market that finds itself in a well-defined trading range is generally better suited for analysis utilizing the RSI.

Try It Yourself

After all the sides of the indicator were revealed, it is right the time for you to try either it will become your tool #1 for trading.

In order to try the indicator performance alone or in the combination with other ones, you can use Forex Tester with the historical data that comes along with the program.

Simply download Forex Tester for free. In addition, you will receive 23 years of free historical data (easily downloadable straight from the software).