PIP ACADEMY
The Ultimate Path to Trading
Length : 6.30 Minutes
Relative Strength Index (RSI)
The relative strength index (RSI) is a momentum oscillator indicator developed by
J. Welles Wilder Jr. that measures the speed and change of price movement. It evaluates the oversold and overbought conditions in the price of an asset by oscillating between two extremes that have a reading from 0 to 100.
Traditionally, the reading below the level 30 is considered as an oversold signal and a reading above the 70 level is considered as an overbought signal.
RSI overbought and oversold strategy is a great tool to pick the tops and the bottoms of a currency pair, which could help to eliminate bad entries. For example, it can be used to avoid entries at wrong places, such as buying on the top and selling at the bottom.
Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range.
One can also add a centre line level of 50 to the RSI , which is between 0 to 100 levels. The centre line level could help to check the price momentum for any change in the direction of the trend.
For example, If RSI is above 50, momentum is considered up and traders can look for opportunities to buy the market. Below is an example on USD/JPY, when the RSI passes above 50, notice that the price start gaining momentum and pushes upward.
On the other hand, a drop below 50 would indicate that price is losing momentum, which could be a development of a new bearish market trend and an opportunity to sell as it is illustrated below.
One simple strategy could be developed based on the overbought and oversold strategy together with the centre-line signal. For example, buy when the RSI passes above 50 and exit when it enters into the overbought zone (above 70). Sell when it passes below 50 and exit the sell when it enters into the oversold zone (below 30).
However, in order for this strategy works effectively, you must have a well tuned RSI and confirm the signals in conjunction with other indicators for a better result.
The default period of the RSI is 14, however one can tune the period according to the market condition. The longer the period the smoother is the RSI (Oscillator) to the changes in the price, and the shorter is the period, the more responsive is the RSI to the recent changes in the price.
A shorter period RSI would generate more signals in general than a smoother one, and more false signals as a result.
Besides the oversold and overbought signals, RSI can also generate signals by looking for divergences and failure swings.
​
Price/Oscillator Divergence
Disagreement between the price and the indicator is called divergence. Divergence is an effective strategy that can spot potential market reversals by comparing the indicator and price direction. Typically RSI will follow the price, if there is decline in price, RSI also declines and if there is a rise, RSI also rises. Thus, divergence occurs when price acts independently from the indicator and the price and the indicator begin heading in two different directions.
A bullish divergence happens when the underlying currency pair makes a lower low and RSI forms a higher low. This signals that the indicator does not confirm the lower low, as a result it could be interpreted that the price is gaining momentum. A bearish divergence occurs when the underlying currency pair makes a higher high and RSI forms a lower high. In this case, RSI does not confirm the new high and this could be considered as weakening momentum.
For a better illustration, below You can see a bearish and bullish divergence on NZD/CHF and USD/JPY respectively.
On the NZD/CHF chart below, it can be seen that the RSI does not follow the price. The price is making a higher high, while the indicator is singling a lower low. This is considered as a bearish divergence, where the indicator does not confirm the new high and price starts losing momentum right after the divergence.
The opposite of the bearish divergence, has happened in the USD/JPY chart below. Here notice that price is making a lower low, while the indicator is doing the opposite by making a higher high. The bullish divergence signals that the indicator does not follow the price and does not confirm the lower low. Thus, as it can be seen the price starts gaining momentum right after.
In general, divergence is a great strategy to spot changes in the trend. However, just like any other indicators and strategies they could generate false signals. Thus, It is important to confirm the signal with other indicators and strategies in order to improve the accuracy rate of the signal generated.