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Relative Strength Index (RSI)

Overview

The RSI possibly constitutes the most popular momentum oscillator among traders and technical analysts. This is probably because it takes into account two of the most significant problems found in the construction of a momentum indicator, namely:

  • The erratic movements often taking place in the present, caused by sudden changes in the value of the underlying instrument due to a sharp advance or decline in the recent past (a few periods back), even if the current prices show little change.
  • The need for a constant oscillation range for comparison and benchmarking purposes.

The RSI attempts to solve both of these problems by using all values in the period rather than just the first and last one, therefore applying more effectively the smoothing necessary to minimise these distortions and also by employing a constant vertical range of 0 to 100.

The term RSI - "Relative Strength Index" is considered to be a misnomer since the term Relative Strength usually refers to the comparison between two different instruments thus causing confusion as to the indicators actual purpose. A more appropriate name might actually be Internal Strength Index since what the indicator actually does is to compare an instruments current and historical strength based on the closing prices of a recent trading period.

Construction

The actual formula is calculated as follows:

RSIt = 100 - (100/1 + RS) = 100 * (RS/1 + RS)

Where the RS is determined by dividing the up-average by the down-average:

RS = (AU/AD)

AU = the average of those days closing higher during the past X number of days

AD = the average of those days closing lower during the past X number days

Once the first calculation has been made, both the AU and the AD values are calculated using an average-off method.

A full guide to the calculation and construction of the RSI indicator is provided in excel format for your better understanding.

Relative Strength Index (RSI)

Interpretation & Trade Signals

The RSI has become popular as a counter-trend oscillator. That is, utilising its signalling, a user is driven to sell when the market is still rising and in an overbought state while driven to buy when the market is still falling and in an oversold state. This setup therefore works best in a range environment when overbought and oversold readings are far more likely to be true signals of a change in direction. The RSI is also much more accurate on the daily charts than on smaller time frames, such as hourly.

There are five basic principles of RSI interpretation;

  • Tops & Bottoms
  • Failure Swings
  • Divergences
  • Trendline Analysis
  • Chart Patterns

Tops & Bottoms

Wilder considers that tops are indicated when the RSI crosses above 70 (overbought state) and then retreats back below this mark, while bottoms are indicated when the RSI falls below 30 (oversold state) and then crosses back above this mark.

The centre line of 50 is also of importance in terms of interpretation. A move above 50 is considered by many to be a representation of average gains surpassing average losses and thus of a bullish sentiment. Conversely, a level below 50 indicates bearishness since the average losses have outdone the average gains.

Failure Swings

A top failure swing, such as the example displayed here, occurs when a peak in the RSI in the overbought band fails to exceed the previous peak in an uptrend, followed by a downside break of a previous low leading the RSI below 70.

Similarly in the opposite situation, a bottom failure swing occurs when a trough in the RSI in the oversold band fails to set a new low in a downtrend, followed by an upside leading the RSI above 30.

Wilder describes failure swings as "very strong indications of a market reversal."

Divergences

Divergences between the RSI and the underlying instrument price line, especially in the two extreme zones are considered by Wilder as “the single most indicative characteristic of the RSI”. For a characteristic example of divergences on both ends see the example that follows.

Trendline Analysis

As with the underlying instrument, plotting trendlines on the RSI helps to realise the trend, even if it is not obvious on the actual price chart, as well as to spot early divergences and failure swings.

Chart Patterns

The RSI can reveal chart patterns that are sometimes not clearly formed on the underlying chart, such as the Head and Shoulders reversal formation below.

Example

Long Entry signal: RSI14 < 50 and there is an apparent positive divergence (and/or failure swing) with the underlying security chart. Enter long when there is actual price confirmation of a higher high and RSI14 > 30.

Change of trend warning: RSI14 > 70 indicating an overbought market.

Long Exit signal: When there is an apparent negative divergence with the underlying security chart. Enter short when there is actual price confirmation of a lower low and a failure swing leading RSI14 < 70 points.

Signal Confirmation provided by shorter term Exponential Moving Average (EMA of 9 periods is used here).

Tips and ideas

While Wilder suggested using 14 periods for the RSI for the daily time-frame, in the case of intraday trading, you should consider optimising the sensitivity of the system. The shorter the time period is set, the more sensitive the oscillator becomes and the wider its amplitude. Therefore, if you are trading on a shorter term basis, you can decrease the time period in order for the oscillator swings to be more noticeable.

If the trading of the RSI results in too many trades being initiated, thus increasing the risk of trading, then you should consider increasing the overbought/oversold levels from 70-30 to 80-20 so that signals are provided through stricter filtering. In strong bull markets it is recommended to increase the overbought level to 80 while in strong bear markets the oversold level should be decreased to 20.

The user may optimise the system through back testing; placing the oversold/overbought bands near the recent actual RSI tops and bottoms

This article is based on Wilder’s original interpretation of the RSI. An alternative approach that is worth investigation can be found in the works of Constance Brown in his book ‘Technical Analysis for the Trading Professional’ quoted in references.

Strengths/Weaknesses

The RSI usually forms tops and bottoms before the underlying price chart.

The RSI usually forms chart patterns, such as Head-and-Shoulders reversal formations, even though they might not be visible on the underlying price chart.

The RSI sometimes shows the existence of Support and Resistance levels more clearly than the underlying price chart.

It might be that the RSI values remain outside the 70-30 oversold/overbought zones for extended periods of time rather than signalling an immediate turn. Therefore, one should be very careful when interpreting RSI during strong trending market conditions.

The RSI, by its nature, looks for reversals in prices. If a market is ranging, initiating long positions when the indicator crosses the oversold limit (>30) and initiating short positions when the indicator crosses the overbought limit (<70), could prove very profitable. If, however, a market is trending, the prices may continue moving in the trending direction, following the short retracement that caused the RSI crossover, thus resulting in entrapping the trader on the wrong side of the market.

Suggested Combinations for EA development

Short-term moving average cross-overs.

Chart reversal patterns as sign of exhaustion.

Support/Resistance levels, retracement zones.

Price - Moving Average crossover signals can be used for confirmation help.

Basic trend analysis can help distinguish strong crossover signals from weak crossover signals.

Stochastic K%D and MACD for reversal confirmations.

Use in Strategy Tune

RSI can be found under the Indicators group in our Strategy Tune menu. With Strategy Tune, we do not have to worry about the calculations and definitions behind the indicator. We just need to drag & drop the indicator in the main window and set the parameters we want to test.

Parameters
Symbol

Input: e.g. EurUsd, GbpYen | Default: Current
If left empty, the instrument symbol used in the relevant chart in MT4 will relate by default.

Time Frame

Input:1m,5m,15m,30m,1h | Default: Current
If set to current, the time frame used in the relevant chart in MT4 will relate by default.

Period

Input: number | Default: 14 periods
Number of periods used in the calculation formula to derive the RSI (see excel spread sheet attached).

Applied Price

Input: Close, Open, High, Low, Median, Typical, Weighted price. | Default: Median PriceValue used to derive the indicator.

Shift Back

Input: Number | Default: 0
Number of periods the output should be shifted back or forth to serve the EA logic.

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References

Welles Wilder - Commodities magazine, in June 1978.

Welles Wilder - New Concepts in Trading Systems, in 1978.

John J. Murphy - Technical Analysis of the Financial Markets

Steven B. Achelis - Technical Analysis from A to Z

Perry J. Kaufman - Trading Systems and Methods

Martin J. Pring - Momentum Explained

Constance Brown - Technical Analysis for the Trading Professional, 2nd Edition