J.Welles Welder built an indicator to identify the strength of the market movement, rather than just comparing the highs and lows and termed it as Relative Strength Index. The Relative Strength Indicator defines the overbought and oversold zones of the market and the RSI crossover from the zones signals a profit booking (correction) rally or trend reversal. So when the trend bucks, make bucks with the RSI Indicator.
Relative Strength Index- The momentum oscillator
Relative Strength Index ranges only between the values of 0-100. It does not extend its value as the price moves. Instead, it confines the strength and momentum to a fixed range. Hence, traders can compare the momentum of the current rally with the previous one. If the current move’s RSI reading doesn’t make a new high (or new low, based on the trend), then it emanates a weaker trend strength, which elevates the chances for a trend reversal.
Overbought and Oversold with RSI Indicator
When the Relative Strength Index prints a reading of above 70 for a stock or currency pair, it suggests the asset is in an overbought condition and is due for a correction.
Likewise, if it prints a reading of below 30, it signifies the asset is in an oversold condition. It instigates a fresh upmove on the asset.
The values 70 and 30 are only indicative. Traders use different combinations, say 20,80 or 30,70, to determine overbought and oversold criteria depending on their style and aggressiveness.
The above chart explains the overbought and oversold zone clearly. The red zone above 70 marks the overbought zone which conveys, not to go long. Likewise, the green area below 30 signals the oversold zone or the not to short zone. When buyers book profits, the index crossovers to the below 70 region which marks the beginning of a corrective rally. The vice-versa happens for a Bullish RSI crossover.
How to trade the trend reversal with RSI crossover?
When the market is in overbought or oversold condition, profit booking is customary. It results in a pullback or throwback. At times it extrapolates to a trend reversal too. Hence RSI crossover has a greater significance as it identifies the reversal at the outset.
Case #1- Bullish RSI Crossover
If the RSI indicator crosses the value of 30 from below, it is assumed as a bullish RSI crossover and traders initiate a long trade.
In the above image, The GBP/AUD pair was in a steep downside rally. A reading of below 30 marks the potential reversal zone. It is a caution zone for traders, where your friend(trend) can become a foe, anytime soon. But it does not mark a trend reversal yet. Only when the values crossovers above 30, it marks the commencement of a new trend. As you can see, once that happens, a robust upmove of 300-400 pips followed.
- The following rally, RSI crossover(both bullish and bearish), depends on the preceding trend rally. The more the prior rally the further the corrective rally.
- RSI crossover identifies the overbought and oversold condition in a trending market. Bollinger Band identifies the overbought and oversold condition in a sideways market.
Case #2 – Bearish RSI Crossover
Likewise, if the indicator crosses the value of 70 from above, traders initiate a short trade assuming it as a bearish RSI crossover.
During the 2017 Bitcoin bubble, Relative Strength Indicator played a significant role in the buying decisions of traders, during trend and trend reversal. It facilitated short trades or bargain buying opportunities for traders by identifying the mild corrections initially. When the indicator crossed the value of 70 from above, the bubble burst and a monstrously sell rally followed.
Chart patterns in RSI
Traders should look out for chart patterns in the Relative Strength Index. Chart patterns like the double top, double bottom and head & shoulder patterns are also be formed in the index. These patterns suggest that the momentum is nearing an end which in turn presents an idea for a buy or sell trade. The patterns may or may not be formed at the overbought and oversold zone.
The above candlestick chart can be meaningless to many. However, if you add RSI Indicator, it renders magic. An inverse head and shoulder pattern formed in the indicator which signaled the momentum reversal. Likewise, the spike is brought to an end with another head and shoulder pattern in the index.
Relative Strength Indicator – Ideal settings
The general setting used for the Relative Strength Index is 14 – period. An aggressive trader uses the value of 9-period for shorter time frames, which produces a higher number of signals, but the accuracy takes a hit. In contrast, a conservative long-term trader uses 21-period to smoothen the waves.
The psychology behind RSI Indicator
J. Welles Wilder created RSI Indicator to solve two main problems. One is to identify the precise momentum of the market amidst the noise and fluctuations in the market. If the market just fixates itself at a single price point and makes noisy movements on either side, it will be certainly difficult to identify the real strength of the market. The Relative Strength Index smoothens and negates the fluctuation to a greater extent. Furthermore, it defines the overbought and oversold conditions of the market. The RSI crossover from the overbought and oversold zones gives an idea of profit booking during overextended rallies to the short-term traders.
Traders always require a comparison of the momentum and Relative Strength Indicator is the best tool to compare the momentum and impulse moves with the previous ones as it ranges only between 0 to 100.
Calculation of RSI
Where RS=Average of H/Average of L
H – up closes in the specific time frame
L- down closes in the specific time frame
RSI Indicator is a momentum oscillator ranging between 0 to 100.
Relative Strength Index, as the name indicates, measures the strength and the momentum in the market.
RSI Indicator defines the overbought and oversold condition of the market.
- Overbought – Above 70.
- Oversold – Below 30.
Bullish RSI crossover – crossing 30 from the below signals corrective rally or trend reversal.
Bearish RSI crossover – crossing 70 from the above signals corrective rally or trend reversal.
Traditional parameter used is 14 period.
Relative Strength Indicator also forms patterns like the double top, the double bottom and the head and shoulder.