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Lesson 9 – RSI
Written on 10 November 2008 by Rod
Relative Strength Index (RSI)
The RSI is an indicator belonging to the oscillator type of indicators. It was developed by Welles Wilder to help investors gauge the current strength of a pair’s price relative to its past performance.
The usefulness of this indicator is based on the premise that the RSI will usually top out or bottom out before the actual market top or bottom, giving a signal that a reversal or at least a significant reaction in pair price is imminent.
The most common way to read the RSI indicator is:
Readings above 70 indicate the prices are overbought and are likely to start falling.
Readings below 30 indicate that prices are oversold and a reversal to the bullish side may occur.
Additionally, the value of 50, can serve the same purpose as the zero line in other oscillators. The slowing down of a current trend or a trend reversal may be signaled by crossing above or below 50.
Selling when the RSI is above 70 or buying when the RSI is below 30 alone, can produce many false signals. A move to those levels is a signal that market conditions are ripe for a market top or bottom but it does not indicate that effectively a top or a bottom will occur. A good strategy is to confirm RSI with divergence.
In divergence, market prices continue to move higher while the RSI fails to move higher during the same time period. And in the case of a bearish market, prices continue to move lower while the RSI fails to move lower during the same time period.
Divergences may occur in a few trading intervals, but true range divergence usually requires a lengthy time frame, perhaps as much as 30 to 60 trading intervals.
The RSI study may help find support and resistance zones. Support and resistance zones often show up clearly on the RSI before becoming clear on the bar chart.
A common practice on some traders is to draw support and resistance lines based on the RSI in the same manner as they would draw trendlines on a chart.
The most commonly used time frame for RSI is the daily chart. In addition, you should see other time frames, usually longer, since weekly charts offer more significance when tracking trending activity.
The recommended setup for RSI, is using a 14-day RSI.
In the last years, the 9 day and 25 day RSIs have also gained popularity, but nothing limits you to try new setups for your RSI. Just remember that the fewer days used to calculate the RSI, the more volatile the indicator.
The time period specified determines the volatility of the RSI. For example, a 9-day time period will be more volatile than a 21-day time span.