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RSI: The Relative Strength Index

RSI: The Relative Strength Index

2011-09-20 19:38:00
James B. Stanley,

One of the first indicators that most new traders get introduced to when discovering the world of Technical Analysis is RSI, or ‘The Relative Strength,’ index.

RSI is classified as ‘a momentum oscillator that measures speed and change of price movements.’

But what does that really mean?

To define this indicator, let’s first get a genesis behind its creation.

RSI was developed by engineer, mathematician, and trader J. Welles Wilder, presented in his ground-breaking work “New Concepts in Technical Trading Systems.”

At the time, Mr. Wilder was a stock and commodities trader that was met with the problem that can be paraphrased along the lines of: “Even though the trend is strong to the upside, how do I know price isn’t TOO expensive for a long position?” Or we can take the same type of statement to the opposite direction: “If the trend is strong to the downside, how do I know price isn’t TOO cheap?”

As traders, many of us have been there before. Take Gold for instance. This is a trend that’s taken place for the better part of 9 years, watching Gold go from less than $300 per ounce to current levels around the $1800 marker.

RSI: The Relative Strength Index

Created by James Stanley

While the ‘Yellow Metal,’ has increased six-fold in value, it hasn’t been all rosy for all traders. Notice that during this uptrend, there were multiple periods in which Gold sold off from its highs. Below is a Daily chart, showing only price action since the middle of October 2010. Notice the ‘Yellow boxes,’ indicating periods at which Gold actually sold off – moving against the strong entrenched up trend we looked at on the previous chart.

RSI: The Relative Strength Index

Created by James Stanley

While the above chart confirms the strong trend to the upside and the potential bias for buy positions, it should also highlight how blindly buying in up-trends could be a tough strategy for traders.

So – I know that it’s not enough to simply buy up-trends, or to simply sell down-trends (even for one of the strongest trends in the world over the past 10 years); how am I going to enter into trades?

This is one of the areas where the Relative Strength Index can help. RSI will grade the price movement exhibited between candles for the last X periods (with x being the input used by the trader, commonly 14 with RSI).

As price changes, RSI will register these changes in price – relative to previous price movements – in an effort to show us ‘strength.’

Higher values on RSI will generally denote Bullishness, and lower values will generally show Bearishness.

Oscillators are often set to boundaries between 0 and 100. Below you will see a diagram of RSI with the lower boundary of zero, and the upper boundary of 100. In this example, I’m using the default input period of 14 (which is the most common input period used with RSI).

RSI: The Relative Strength Index

Created by James Stanley

There are a few additional lines of note with the Relative Strength Index.

You will notice the ‘Mid-line,’ at 50 is denoted. Traders will often-times use this as a cut-off. If RSI is reading above 50 – traders will consider the ‘trend to be bullish.’ If RSI is below 50, traders will often consider the ‘momentum to be bearish.’

RSI: The Relative Strength Index

Created by James Stanley

Traders have also taken this a step further, with the idea that if RSI goes over 70 – the pair is not only bullish, but potentially even ‘Overbought.’ Or on the other side, traders often assume that if RSI is below 30 – the pair isn’t just bearish… it may be ‘Oversold.’ The RSI indicator below indicates these levels:

RSI: The Relative Strength Index

Created by James Stanley

So now that we know a little bit about RSI, and how traders can look at this indicator: How can this help me enter into the Gold trade mentioned at the beginning of the section?

Well, this is one of the more common uses of the Relative Strength Index. Remember – from the first price chart that we looked at we saw the huge uptrend that Gold has exhibited. As a trader, I want to try to get the odds on my side, so I want to look at taking only BUY positions on this chart.

And now that I know I want to buy, I can simply watch RSI to wait for a ‘Signal.’ And in the case of Buy positions (aka Long Positions), I can wait for RSI to read ‘Oversold,’ indicating to me that near-term weakness has created a potential buying opportunity in this uptrend.

RSI: The Relative Strength Index

Created by James Stanley

In the case of a Long (or Buy) position, I will wait for RSI to read ‘Oversold,’ and when RSI is leaving the ‘Oversold,’ region (below 30), I will look to buy.

Below is an example of the same entry strategy being used in a Short (or Sell) position:

RSI: The Relative Strength Index

Created by James Stanley

As RSI comes down and through 70 (indicating to the trader that price is leaving ‘Overbought,’ territory), I look to initiate my short position.

This is one of the more common uses of the Relative Strength Index.

In our next article, I’ll bring RSI together with another common technical indicator to create a mechanism by which I can look to buy or sell in trending conditions.

Next: How to Trade with Stochastic Oscillator(45 of 63)

Previous: Exponential Moving Averages

James Stanley contributes to the Instructor Trading Tips section of DailyFX.

To join James Stanley’s distribution list, please click here.

Thank you very much for your time, and Happy Trading!

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