The Relative Strength Index is a price-following oscillator that fluctuates in a range between 0 and 100. One of the most common techniques of RSI analysis is to search for divergences where the price makes a new high while the RSI fails to break above its previous peak.
Such a divergence indicates a potential trend reversal. If the RSI then turns down and sinks below its bottom, it completes the so-called failure swing. This failure swing is considered to be a confirmation of a soon price reversal.
There are several applications of the RSI for chart analysis.
Tops and bottoms
The RSI usually forms peaks above 70 and bottoms below 30. As a rule, these tops and bottoms anticipate actual price swings on the underlying chart.
Chart patterns
The RSI often forms graphical patterns such as Head and Shoulders and Triangle which are not necessarily visible on a price chart.
Failure swings (support or resistance breakouts) occur whenever the RSI rises above the previous high or falls below the prior low.
Support and Resistance
On an RSI chart, support and resistance levels are seen even more clearly than on a price chart.
Divergences
As we have mentioned above, divergences take place when the price makes a new high or low that is not confirmed by a new high or low on the RSI chart. Prices usually correct in the direction of the RSI.
The Relative Strength Index was invented and developed by Welles Wilder in the mid-1970s. The RSI is one of the most popular and widespread oscillators.
When it comes to the RSI, apart from traditional oscillator analysis, chartists also apply graphical analysis with support, resistance, and trend lines as described above.
To calculate values of the oscillator, use the following formula:
RSI = 100 - [100 / (1 + RS)]; RS = AUx/ADx
where x is the number of days;
AU is an average of earlier prices that closed higher for x days;
AD is an average of earlier prices that closed lower for x days.
This leading or coincident indicator measures the strength of bullish or bearish sentiment in a predefined period by tracking changes in closing prices during that time.
The RSI fluctuates between 0 and 100. Horizontal reference lines that divide overbought and oversold areas must run across the highest peaks and lowest bottoms. As a rule, they are drawn at the levels of 30 and 70. However, in strong trending markets these lines may be shifted to 40 and 80 (in an uptrend), or 20 and 60 (in a downtrend). The basic rule here may be formulated as: draw reference lines so that the RSI spends no longer than 5% of its time above the highest and below the lowest levels in the previous 4 to 6 months. These lines should be readjusted every three months. There are three types of trading signals generated by the RSI: divergences, RSI chart patterns, and levels.
Bullish (positive) divergences give buy signals.
They take place whenever prices reach a new low while the RSI makes a higher bottom than the one recorded during its previous downturn. A trader should go long at the moment when the RSI starts going up from the recent bottom, and place a stop order below the most recent lowest price. A buy signal would be particularly strong if the preceding RSI bottom is below the lower reference line, and the most recent bottom is above this line.
The opposite is true in the case of bearish (negative) divergences.
Likewise, a sell signal would be especially strong if the preceding RSI peak is above the upper reference line, and the most recent peak is below it. Out of all technical indicators, traditional graphical methods work best with the Relative Strength Index. The dynamic of the RSI chart precedes prices by several days, providing hints at further market behavior. The RSI trend line reverses one or two days before the price trend.
Rules for RSI trend line analysis:
Place long orders when the RSI breaks below the falling RSI trend line.
Place short orders when the RSI breaks above the rising RSI trend line.
When the RSI rises above the upper reference line, it indicates a high level of bullish activity. At the same time, the market is in an overbought condition, so keep in mind that a wave of sell-offs is about to start.
When the RSI falls below the lower reference line, we observe strong bearish pressure. Take into account that the market is then oversold, and traders will start making bullish bets in the short term.
Place long orders based on RSI overbought signals only when the weekly trend is rising.
There is one more important point to grasp when dealing with oscillators.
Remember that any strong trend, whether it is rising or falling, usually pushes an oscillator to extreme areas.
In this case, indicators can give premature overbought or oversold signals, which may lead to an early exit from profitable positions. For example, in a strong uptrend, the market may stay in an overbought area for quite a long time. However, the mere fact that an oscillator hovers around extreme points does not necessarily mean that a trader needs to liquidate long positions immediately or open short orders in a strong uptrend. The first time when an oscillator has touched an overbought or oversold area is usually only a warning. However, if the curve returns to these critical levels once again, this is a more important signal that requires your full attention. If further moves fail to confirm an upcoming rise or fall, the oscillator forms a double top or bottom. This means that a divergence may possibly take place, so a trader is recommended to protect existing positions. If the curve turns in the opposite direction and crosses the previous peak or bottom, the divergence signal is confirmed. However, even an exit from a position may turn out to be premature, at least until there are any signs of a trend change.
The indicator’s exit from an oversold area supported by a bullish divergence has given a strong buy signal.
Such a divergence indicates a potential trend reversal. If the RSI then turns down and sinks below its bottom, it completes the so-called failure swing. This failure swing is considered to be a confirmation of a soon price reversal.
There are several applications of the RSI for chart analysis.
Tops and bottoms
The RSI usually forms peaks above 70 and bottoms below 30. As a rule, these tops and bottoms anticipate actual price swings on the underlying chart.
Chart patterns
The RSI often forms graphical patterns such as Head and Shoulders and Triangle which are not necessarily visible on a price chart.
Failure swings (support or resistance breakouts) occur whenever the RSI rises above the previous high or falls below the prior low.
Support and Resistance
On an RSI chart, support and resistance levels are seen even more clearly than on a price chart.
Divergences
As we have mentioned above, divergences take place when the price makes a new high or low that is not confirmed by a new high or low on the RSI chart. Prices usually correct in the direction of the RSI.
The Relative Strength Index was invented and developed by Welles Wilder in the mid-1970s. The RSI is one of the most popular and widespread oscillators.
When it comes to the RSI, apart from traditional oscillator analysis, chartists also apply graphical analysis with support, resistance, and trend lines as described above.
To calculate values of the oscillator, use the following formula:
RSI = 100 - [100 / (1 + RS)]; RS = AUx/ADx
where x is the number of days;
AU is an average of earlier prices that closed higher for x days;
AD is an average of earlier prices that closed lower for x days.
This leading or coincident indicator measures the strength of bullish or bearish sentiment in a predefined period by tracking changes in closing prices during that time.
The RSI fluctuates between 0 and 100. Horizontal reference lines that divide overbought and oversold areas must run across the highest peaks and lowest bottoms. As a rule, they are drawn at the levels of 30 and 70. However, in strong trending markets these lines may be shifted to 40 and 80 (in an uptrend), or 20 and 60 (in a downtrend). The basic rule here may be formulated as: draw reference lines so that the RSI spends no longer than 5% of its time above the highest and below the lowest levels in the previous 4 to 6 months. These lines should be readjusted every three months. There are three types of trading signals generated by the RSI: divergences, RSI chart patterns, and levels.
Bullish (positive) divergences give buy signals.
They take place whenever prices reach a new low while the RSI makes a higher bottom than the one recorded during its previous downturn. A trader should go long at the moment when the RSI starts going up from the recent bottom, and place a stop order below the most recent lowest price. A buy signal would be particularly strong if the preceding RSI bottom is below the lower reference line, and the most recent bottom is above this line.
The opposite is true in the case of bearish (negative) divergences.
Likewise, a sell signal would be especially strong if the preceding RSI peak is above the upper reference line, and the most recent peak is below it. Out of all technical indicators, traditional graphical methods work best with the Relative Strength Index. The dynamic of the RSI chart precedes prices by several days, providing hints at further market behavior. The RSI trend line reverses one or two days before the price trend.
Rules for RSI trend line analysis:
Place long orders when the RSI breaks below the falling RSI trend line.
Place short orders when the RSI breaks above the rising RSI trend line.
When the RSI rises above the upper reference line, it indicates a high level of bullish activity. At the same time, the market is in an overbought condition, so keep in mind that a wave of sell-offs is about to start.
When the RSI falls below the lower reference line, we observe strong bearish pressure. Take into account that the market is then oversold, and traders will start making bullish bets in the short term.
Place long orders based on RSI overbought signals only when the weekly trend is rising.
There is one more important point to grasp when dealing with oscillators.
Remember that any strong trend, whether it is rising or falling, usually pushes an oscillator to extreme areas.
In this case, indicators can give premature overbought or oversold signals, which may lead to an early exit from profitable positions. For example, in a strong uptrend, the market may stay in an overbought area for quite a long time. However, the mere fact that an oscillator hovers around extreme points does not necessarily mean that a trader needs to liquidate long positions immediately or open short orders in a strong uptrend. The first time when an oscillator has touched an overbought or oversold area is usually only a warning. However, if the curve returns to these critical levels once again, this is a more important signal that requires your full attention. If further moves fail to confirm an upcoming rise or fall, the oscillator forms a double top or bottom. This means that a divergence may possibly take place, so a trader is recommended to protect existing positions. If the curve turns in the opposite direction and crosses the previous peak or bottom, the divergence signal is confirmed. However, even an exit from a position may turn out to be premature, at least until there are any signs of a trend change.
The indicator’s exit from an oversold area supported by a bullish divergence has given a strong buy signal.
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