How Does the Relative Strength Indicator Function
Have you read Welles Wilder's "New Strategies in Technical Trading Systems?" If you haven't, I would advise reading the book today. If you want to trade the RSI, learn about it from the original text and apply the original RSI knowledge to your trading. Don't settle for the endless stream of reviews and technical explanations on the nature of this remarkable volume and don't be satisfied with simply understanding a bit about his technical indicators. No, I think a proper foundation in trading starts at the source, not the endless stream of late comers who have adapted aspects of the book into their trading systems. Now let's get started with the RSI.
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Let me ask you a quick question. What do all of the following have in common?
1. Relative Strength Indicator
2. Directional Movement Indicator
3. Average Directional Index
4. Parabolic Stop and Reverse
5. Average True Range
6. Wilder Smoothing Average
2. Directional Movement Indicator
3. Average Directional Index
4. Parabolic Stop and Reverse
5. Average True Range
6. Wilder Smoothing Average
They were all in one book! Yep, "New Strategies in Technical Trading Systems" is the source. Of course, today we are going to concentrate on just one of those indicators, the Relative Strength Index, or RSI.
RS = Average of x days' up closes / Average of x days' down closes
The RSI is an indicator that compares recent gains and recent losses to formulate a system for determining overbought and oversold conditions. I can't see it as a stand-alone indicator, as it tends to whipshaw you in and out of the markets, but it is the perfect indicator to use in conjunction with other indicators. I use it as a confirming indicator for my primary indicator.
There are three primary areas to pay attention to when trading the RSI. The overbought area is derived from the data when the indicator hits 70. The oversold indication is derived from data when the indicator hits 30. In his original thesis, both these readings (70, 30) were buy and sell points of the RSI. Since the RSI is used to measure the strength of the underlying security, there is a wealth of information to be gleaned from the RSI. Again, I caution you in trading the RSI as a primary indicator.
Another system uses the RSI in a similar manner, except it focuses on the 50 line in the RSI. Some believe that when the RSI pierces the 50 line going upward a buy signal is generated, and the corollary is true also, when the line is headed downward through the 50 line, a short signal is generated. While I am aware of these two trading methods, it's not what I am looking for in the RSI, though the information is valuable for confirming trade decisions.
No, I want to look at price divergences with the RSI. When the RSI is headed one way and the price action on the chart is headed another I like to take notice, especially if I am currently in a trade. Divergent indicators are the stuff of gold and they are hard to come across, especially in short term trading, but the RSI shines at its assigned task. When price is still headed in an upward direction and the RSI joins that movement direction, I am looking for a point in time when the RSI changes direction and it usually begins to swing before the price movement reflects the deteriorating underlying short term trend. Put in less esoteric terms, if the price is going up and the RSI starts to head down, you better be prepared to take quick action. Convergence and divergence are what makes guys like me, who trade with price action and oscilllators, feel good. Any information that I can glean about what is happening in the market is helpful, especially when you are trying to scan your screen for something that isn't necessarily reflected in the charts.
I feel using the RSI makes me a more nimble, more informed trader. It generally occupies the middle of the indicator row, second from the top. Once I am in a trade I generally keep a close watch on what the RSI is trying to tell me and then plan my strategy accordingly. My recommendation is to give the RSI a try and see if makes sense in your overall trading strategy. Are you paying attention to divergent indicators? You should be.
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