Relative Strength Index (RSI)
Relative Strength Index (RSI) is developed by Welles Wilder, one of the greatest contributors in the Technical Analysis regime. RSI is a momentum oscillator that measures the rate at which prices are changing. According to Wilder, RSI is considered overbought when above 70 and oversold when below 30. The indicator also generate signals by spotting divergence, crossovers and failure swings.
RSI is bounded in the range from 0 to 100. The upper zone above 70 is called overbought zone and the lower zone below 30 is called oversold zone. When a stock for security has risen far enough that its oscillator reach the overbought zone, the stock is said to be overbought and when price has fallen far enough that its oscillator reach the oversold zone, the stock is said to be oversold.
When its oscillator moves in the overbought/oversold zone, it indicates that a reversal is imminent. However it only works best in a sideways market; in which the overbought and oversold levels are excellent indications of reversal levels. In a strongly trending market, it might be deceiving because oscillator might stay in the overbought/oversold zone for a while and you will probably miss a huge profit from trending market because of getting out too soon.
Let’s look at an example:
IBM daily chart shows us a lot of overbought and oversold situation in the market.
The basic rule for divergence is that when a price reaches a new high, the oscillator should also reach a new high. And when the price reach a new low, the oscillator should also reach a new low. If it is not the case then obviously a bullish trending market is rising at a decreasing rate, which in turn gives us an indication about the internal weakness of this bullish trend and a glimpse of a reversal.
If the oscillator fails to confirm a new high in price, it is said to be bearish divergent. If oscillator fails to confirm a new low in price, it is said to be bullish divergent.
Let’s look at some examples:
–On PFE daily chart, we have 1 bearish and 1 bullish divergence as RSI fails to confirm the price.
FLC ( VN-stock) daily chart, we see 2 powerful Bearish Divergence as when Price makes new high, the RSI makes lower high and hence fails to confirm the price.
2 more examples of Bullish Divergence:
Price makes new low when RSI fails to. We have very clear 2 bullish divergences.
3) Crossover Buy/Sell signal
Originally introduced by William, RSI cross 30 from the below should generate a Buy signal and a crossover of the 70 level from the above should be a Sell signal. However, We and a lot of traders found these signals extremely unreliable and wouldn’t recommend any of traders to execute trade on the signal generated by RSI.
Indeed, there is a method called “RSI is wrong”. Active Trader Magazine (August 2004) tested this system on 19 futures from 1994 to 2003 with the rules: buy when RSI penetrates above 75 and sell when RSI crosses below 25. The results were very good especially with long positions.
In short, my advice would be TEST ANY SYSTEM BEFORE USING IT IN YOUR TRADE. I and a lot of traders might be wrong as 90% of traders in the market are not making money.
4) Failure Swings
Failure Swing is a very powerful techniques provided with RSI.
In the left, entitled the Bearish Failure Swing, the high tops out the 70 level s, then falls to about 60 level and rally to retest the 70 level but fall short, thus results in a “failure swing”. We will wait till RSI falls to make new low and sell.
The opposite setup happens in a Bullish Failure Swing. The RSI falls below 30, then rally to about 40 level and goes down to restes 30 level but fall short, thus results in a failure swing. We will go long when RSI breaks the last high.
Let’s take a look at some real-life examples:
AUD/USD H4 chart shows a perfect Failure Swing Top. RSI comes is overbought zone, get rejected back, come down again but fail to break 70 level. The candle marked on the chart confirms the completion of Failure Swing Top as RSI make new low that day. Sell order should be opened at the end of that day or the next day.
2 more Failure Swing bottom on RY(NYSE) daily chart.
Identifying Divergence and Failure Swings in real market condition requires a lot of practice hence Open the chart of your favorite stock or currency and start practicing now!