The Relative Strength Index

The relative strength index is an indicator which can be used to identify overbought and oversold levels. The RSI is an indicator which is composed of a single line which oscillates between 0 and 100. The most common way to the read the relative strength index is to use points where price is considered to be overbought or oversold. The most frequently used points are 70 for overbought and 30 for oversold. When the RSI is greater than 70, price is often considered to be overbought and when it is less than 30, price is considered to be oversold. The RSI is a powerful indicator which can be used in many different ways.

The Mathematics

Before a trader decides to use the relative strength index, it is highly encouraged that he gain a mathematical understanding of how the RSI works. We feel that knowledge of the exact formula is not necessary but rather what goes into the creation of the indicator. The relative strength index is calculated by determining if price went up or down in a given period and then taking an average and converting it to a scale of 0 to 100. The converted average is what the trader sees on his chart when he uses the RSI.

An Important Note

It is important that before using the RSI the trader recognize that it is an oscillator. Since it is an oscillator, it is almost useless in a trending market. Should a trader decide to use the relative strength index in his trading, he must first draw relevant support and resistance lines as well as trend lines to determine if the market is trending or in a trading range. The RSI can be effectively used when price is in a trading range.

Method 1 ? Turning Points within a Range

The most basic and perhaps the most used method for trading the RSI is using it to determine turning points within a range. Since the RSI shows locations where price is overbought or oversold, it can easily be used to spot locations where price has a high likelihood of turning within a trading range. If a trader is alert and employing a trading range strategy, he could initiate a short position when the RSI shows oversold and price is nearing resistance. Alternatively, if price were moving downwards and the RSI is showing that it is oversold, the trader could initiate a long trade if support were nearby. As soon as the trader initiates a position, his first stop should be at a point outside of the range. For example, if the trader enters a short position, he should place a stop a short distance above the top of the trading range. As the trade progresses, he should aggressively manage stops to protect profit and perhaps catch the beginning of a new trend.

Overbought Oversold

Summary ? To Trade a Turning Point within a Range
1. Draw key support and resistance areas as well as trend lines.
2. Determine that price is in a trading range and not trending upwards or downwards.
3. Purchase at support if the RSI is oversold (less than 30) or sell at resistance if the RSI is overbought (greater than 70).
4. Set initial stop outside of the trading range at a short distance beyond the range.
5. Aggressively manage stops to protect capital.
6. Never trade against the primary trend.

Method 2 ? Contrarian Indicator

While the RSI gives excellent signals within a trading range, it can also be used to spot locations where a trend is likely to continue. One of the basic theories of technical analysis is that while a trend is in motion, it will continue to stay in motion. This means that if price is going up, it will more than likely keep going up; or if it is going down, it will more than likely keep going down. In the terms of the relative strength index: if price is overbought, it will more than likely stay overbought or if it is oversold, it will more than likely stay oversold. A trader armed with this knowledge can potentially catch a trend while it is in full force and exit as soon as momentum wanes. If a trend is first determined with trend lines or moving averages, a trader can then monitor the RSI and execute a trade as soon as the RSI becomes overbought or oversold in the direction of the trend. For a more precise guideline, if an uptrend is in existence and the RSI rises above 70, the trader could profit by going long until the RSI falls back below 70. The opposite would hold true for an established downtrend: if price is in a downtrend and the RSI falls below 30, the trader could initiate a short position until the RSI closes back above 30.

RSI Contrarian

Summary ? To use the RSI as a Contrarian Indicator
1. Draw key support and resistance areas as well as trend lines.
2. Determine that price is in an established trend and not a trading range.
3. Purchase as soon as the RSI closes above 70 or short when the RSI closes below 30.
4. Use trend following rules to determine stop locations ? step stops beneath retracements as they form.
5. Exit as soon as a stop is hit or the RSI closes back across the overbought or oversold level.
6. Never trade against the primary trend.

Method 3 ? Divergences

Similar to our discussion of the MACD, divergences using the RSI can be very powerful signals. A divergence is simply when price travels one direction while an indicator travels another. When price is travelling upwards and making higher highs and the RSI is travelling downward making lower lows, price will more than likely correct in the direction of the RSI. This is not always the case, but it occurs very frequently and provides the trader ample opportunity to catch the top of a trend and profit on a reversal. In order for a trader to correctly position himself to trade divergences, he must first draw trend lines to ensure that his trade is valid. If price is trending one direction while the RSI is trending another direction, as soon as support or resistance is broken, it is time to trade. Below is an image representing a divergence trade and where a trader should initiate his position.

RSI Divergence

Summary ? To trade a Price-RSI divergence
1. Draw key support and resistance as well as trend lines to show the movement of price.
2. Draw trend lines to the peaks and troughs of the RSI and price action to look for a divergence.
3. Initiate a trade as soon as price clears near term support or resistance in the direction of the reversal.
4. Set initial stop below or above a prior retracement.
5. Move stop to more prior retracements as they develop and clear.
6. Never trade against the primary trend.