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The RSI (Relative Strength Indicator) is best described as a price movement momentum indicator. It is also used to indicate when the market has moved in one direction too quickly and is due for a correction. The RSI is a very popular technical analysis indicator among day traders because it allows the trader to quickly identify trading opportunities as well as provide a powerful tool for automating the trading process.
By default, the RSI ranges from 0 to 100 and is drawn using the trading data from the last 14 periods. However, a good trading platform or charting package will allow for the modification of these parameters to suit a trading strategy or a trader’s preferences. An instrument is said to be overbought and due for a pull back once the RSI reaches the 70 level. Likewise, if the RSI reaches the 30 level, it is an indication that the instrument is oversold and has become due for a pullback. Here are some of the RSI trading strategies that a day trader might use.
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The RSI Formula
Assuming that the indicator is set to use the standard 14 periods, the RSI levels are calculated using the following formula:
RSI = 100 - ------------
1 + RS
RS = Average Gain/Average Loss
Average Gain = [(previous Average Gain) x 13 + current Gain]/14
First Average Gain = Total of Gains during past 14 periods/14
Average Loss = [(previous Average Loss) x 13 + current Loss]/14
First Average Loss = Total of Losses during past 14 periods/14
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Entering on Pull Backs
Especially in a trending market, a RSI trading strategy can be very powerful in identifying good entry points. For this RSI trading strategy to work, the day trader must first determine the market’s trend. To do this the trader might use trend lines, EMA lines or fundamental analysis among other things. Especially when the RSI converges with trend lines or moving averages, it can indicate that an excellent low-risk trading opportunity exists. The overbought and oversold levels, in this instance, indicate that the market has overextended itself by going against the trend too far and too quickly. For example, if the overall market trend is bullish, look for oversold opportunities to buy into the trend and visa versa.
However, it should be noted that in cases where the market is moving hard and fast, the market might not respond to the overbought and oversold levels. Consequently, the RSI should not be used by itself; the trading strategy must use another technical analysis indicator to filter bad signals.
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A second way that traders use the RSI in their trading strategies is to spot divergences between the RSI and the market’s price action. Divergences can act as an indicator that a move is loosing its momentum and could soon reverse its direction. A divergence occurs when the market makes a new high or low without sending the RSI into an overbought or oversold state. The reversal setup can be confirmed by a head and shoulders pattern or a break in a trend line. In any case, divergences usually signal that the market has lost some steam and is likely to reverse its direction.
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Identifying Strong Market Trends
If the market ignores the overbought and oversold levels of the RSI indicator, it is an indication that there is a lot of conviction behind the current move. Therefore, the trader should be wary about entering against the current direction, even if the RSI is at its extremes. While a small bounce can be expected whenever the market hits a RSI level, it is likely that the instrument will continue in the same direction until the market is done pricing-in whatever factor is causing the price movement.
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No indicator is perfect, but a trader can improve his chances of becoming successful by using the technical analysis indicators that a large percentage of traders use in their trading strategies. One of those indicators is the RSI. While the RSI is a powerful and popular indicator, it must never be used by itself but in collaboration with a suite of indicators for identifying good trading entries. In any case, it is a good technical analysis indicator for identifying possible turnaround points and low risk trades in a trending market.