By Rob Colville on December 2, 2016 in
Sometimes, in addition to analysing pure price action on the charts, technical traders will utilize mainstream or even proprietary indicators to confirm or validate their trade idea. And while there’s practically no limit to the indicators being used today, few are more popular than the Relative Strength Index (RSI), and given its reputation for accuracy and reliability across all markets, it’s easy to understand why.
The RSI itself isn’t enough to generate a valid buy or sell signal under the Lazy Trader methodology, but it’s still one we like to add as a chart supplement. One primary advantage of the RSI is that it gets charted independently, so it can be consulted without blurring price action on the actual chart. Here’s what the Relative Strength Index (RSI) signifies, how it can be applied by technical traders across all markets, and a real market example that shows the RSI being used to further validate a price-action-inspired trade set-up.
By definition, the Relative Strength Index (RSI) is a momentum indicator used to reflect the overbought or oversold nature of a particular market or asset. It’s calculated as follows:
Relative Strength Index (RSI) = 100 – 100 / (1+RS)
RS = Average Gain / Average Loss over ‘x’ number of periods, like the prior 14 days, for example
The “typical” range for RSI readings is traditionally 30-70, with the 70+ area considered “extremely overbought” and readings of 30 or lower considered “extremely oversold.” Some traders use 80 and 20 for even greater confirmation, though.
A graphical representation of the Relative Strength Index (RSI) (see bottom panel) on an historical EURUSD price chart (top panel) is shown here:
Technical Indicators: Relative Strength Index (RSI)
One important item of note is that the Relative Strength Index (RSI) is easily confused with, but is not the same as relative strength, which measures two separate markets or assets using a ratio line to determine the asset for which price is performing the strongest and weakest, respectively.
With the above chart as a guide, it’s clear to see how obtaining an RSI reading is quite simple and straightforward. However, different traders tend to use information from the RSI differently, with some traders taking trades based only on extreme RSI readings, and others simply using the RSI as a potential confirmation signal once a valid price pattern is generated on the chart.
As such, two primary applications of the Relative Strength Index (RSI) are:
Direct RSI Buy or Sell Signals: RSI at or near the 30 (oversold) level could be taken as a buying opportunity (see grey shaded area above), particularly if price is also at a notable low level. Conversely, an RSI reading at 70 or above could represent a sell signal for the asset in question (see pink shaded areas above), especially with price at a recent or period-based high as well. These scenarios represent potential reversal trades, which are low probability and high risk, by nature, but are also worthwhile opportunities from time to time.
RSI Divergence: RSI divergence is present whenever the asset or currency pair in question is making new highs or lows, but the RSI is not. This might suggest that traders and investors have yet to pile into a momentum move at full force, leaving additional room for said move to continue to either the upside (if bullish divergence) or downside (if bearish). This scenario might be present, say, when buying dips or selling rallies within an overall uptrend or downtrend, respectively.
As we mentioned, the Lazy Trader methodology requires the existence of a proven chart pattern like a doji or pin bar reversal to trigger into a given trade set-up, so while direct signals from the Relative Strength Index (RSI) aren’t valid alone, RSI divergences can be especially useful for buying and selling long-term trend moves. The below set-up in SGDJPY helps illustrate:
Technical Analysis: RSI Divergence in SGD/JPY
As shown on the price action pane of the weekly chart, although this pair has been in a lengthy uptrend (not shown) since 2011, a rather complex retracement lower has been in place since mid-2015. But even as price put in lower highs and lower lows for much of 2016, notice how the RSI (lower chart pane) did not.
This bullish divergence seen in the RSI provided added validation in mid-November, when we bought SGDJPY just before the three consecutive (and sizable) weekly gains materialised. The decision to buy was justified by multiple factors, which included:
By our own rules for trading, a qualifying chart pattern is all that is truly needed to enter into a particular set-up, but can you see how we built a much stronger case for this SGDJPY trade by examining potential confirmation signals such as the RSI divergence?
With multiple factors including the RSI divergence aligned in favour of buying SGDJPY, this became a set-up we were able to take with conviction and confidence. So in large part, that’s the benefit of using the Relative Strength Index (RSI) when trading long-term trends like this one and any number of others that are always in play across a range of markets, assets, and currency pairs.
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