History
Relative Strength Index
was developed by J.Welles Wilder Jr. and introduced in
his book 'New Concepts In Technical Trading Systems'. It
is one of the most popular technical tools around.
Relative strength Index (RSI) is measured on a scale
from 0-100 with a reading above 70 being overbought and
a reading below 30 being oversold. Originally he
recommended a 14-day period as the setting but many
other time periods have now become popular. Wilder
discusses 5 uses of RSI in his book.
Tops and Bottoms
These are indicated when
the readings go above 70 (top) and below 30 (bottom)
Chart Formations. The RSI may form chart
formations that may or may not appear on the actual bar
chart e.g. you might see a head and shoulders formation
on the RSI but not on the bar chart.
Failure Swings
When the RSI goes above
70 or below 30 this is a strong indication that the
market is ready for a reversal.
Support and Resistance
It is sometimes more
apparent that support or resistance is forming in the
RSI than can be seen on the bar chart.
Divergence
When price makes a new
high or low and this is not confirmed by the RSI this
can be a very strong indication that a reversal is
imminent.
My Use Of RSI
My own favorite use of
RSI is that of divergence. When the security you are
trading makes a new high and the RSI turns down that is
bearish divergence.
The same is true of
bullish divergence. When price makes a new low and the
RSI turns up that is bullish divergence.
I also prefer to see
divergence at major tops and bottoms. That is to say, if
we have been in an up trend for some time and I am
already thinking this might be topping and I see
divergence then I am a lot more confident that it has in
fact topped and vice versa.
I don't like to use RSI
as a sole trigger for a new position but rather I like
to use it in combination with other indicators to help
build a picture. You will notice that in most cases of
divergence the security makes a low as does the RSI,
then the RSI begins to turn up but the security
continues down. The same applies to highs.
Now the security makes a
new low and the RSI does come down but not as low as the
previous low and that is the point where action can be
taken. The fact that the RSI has not dropped lower than
its previous low and the price has, is the point of
recognition. If I also have a break of a trend line or
it has reach a projection or some other confirming
analysis then I would enter a trade.
As you can see from the
two charts below one is exhibiting bearish divergence
and the other bullish divergence. In both cases it
signified the end of a trend.
USD/CHF
USD/CHF
