Technical analysis is a method of predicting future price movements using charts showing past market price action. There are many different technical analysis indicators to choose from, each with its own merits and downfalls. One indicator which is particularly popular with experienced traders is the Relative Strength Index.
The Relative Strength Index. Also known as the RSI, is a technical indicator that shows when the market is overbought or oversold. The RSI is an oscillator that reads a value between 0 and 100; measuring how strong or weak a price is over a period of time. It is a leading indicator.
The RSI formula gives a better understanding of how it’s calculated:
RSI = 100 – (100/(1+RS)
RS (Relative Strength) = Average gain/Average loss
A value of 70 or above indicates that the market is overbought, therefore the price could soon reverse and sell off. After confirmation of a reversal, a sell trade should be placed.
Meanwhile, RSI readings of 30 or below denote an oversold market. Here we could expect the market to start rising again, therefore after confirmation of a reversal we would look to open a buy position.
Trend formations are easily identified by RSI. A technical term called centreline crossover (or RSI divergence) is used to describe rising or falling trends, which give bullish or bearish signals. When the RSI value moves above 50 the market is strengthening, whereas a movement below 50 heading towards 30 indicates a weakening of the market trend. In other words, 50 is the mid point which separates two areas, the upper and the lower areas. In an uptrend the RSI will be above 50, in a downtrend the RSI would be below 50.
The RSI’s measurements can be susceptible to sharp and sudden price movements making the indicator weak giving false signals. In addition, signals that do denote an overbought or oversold market can see price extend beyond the signal, this is particularly true when the market is ranging.
Trading based upon a centreline crossover should be exercised with caution, after a price reversal, price action should close two or three candles in a row in the direction of your trade before placing a trade.
To offset the potential flaws of RSI use the indicator in conjunction with others and safeguard losses by risk managing. Stop losses can minimise trade losses, they should be placed upon recent swings that occurred at the reversal you are trading.
Knowing when to take profit is equally as important as making profit. An RSI signal in the opposite direction should prompt an exit from the market based on the assumption that price action is going to reverse, unless there is evidence that the price move is going to end.