David Waring

In our last lesson we looked at 3 different ways to trade the MACD indicator. In today’s lesson we are going to look at a class of indicators which are known as Oscillators with a look at how to trade one of the more popular Oscillators the Relative Strength Index (RSI).

An oscillator is a leading technical indicator which fluctuates above and below a center line and normally has upper and lower bands which indicate overbought and oversold conditions in the market (an exception to this would be the MACD which is an Oscillator as well). One of the most popular Oscillators outside of the MACD which we have already gone over is the Relative Strength Index (RSI) which is where we will start our discussion.

The RSI is best described as an indicator which represents the momentum in a particular financial instrument as well as when it is reaching extreme levels to the upside (referred to as overbought) or downside (referred to as oversold) and is therefore due for a reversal. The indicator accomplishes this through a formula which compares the size of recent gains for a particular financial instrument to the size of recent losses, the results of which are plotted as a line which fluctuates between 0 and 100. Bands are then placed at 70 which is considered an extreme level to the upside, and 30 which is considered an extreme level to the downside.

Example of the RSI Indicator


The first and most popular way that traders use the RSI is to identify and potentially trade overbought and oversold areas in the market. Because of the way the RSI is constructed a reading of 100 would indicate zero losses in the dataset that you are analyzing, and a reading of zero would indicate zero gains, both of which would be a very rare occurrence. As such James Wilder who developed the indicator chose the levels of 70 to identify overbought conditions and 30 to identify oversold conditions. When the RSI line trades above the 70 line this is seen by traders as a sign the market is becoming overextended to the upside. Conversely when the market trades below the 30 line this is seen by traders as a sign that the market is becoming over extended to the downside. As such traders will look for opportunities to go long when the RSI is below 30 and opportunities to go short when it is above 70. As with all indicators however this is best done when other parts of a trader’s analysis line up with the indicator.

Example of RSI Indicator Showing Overbought and Oversold


A second way that traders look to use the RSI is to look for divergences between the RSI and the financial instrument that they are analyzing, particularly when these divergences occur after overbought or oversold conditions in the market. These divergences can act as a sign that a move is loosing momentum and often occur before reversals in the market. As such traders will watch for divergences as a potential opportunity to trade a reversal in the stock, futures or forex markets or to enter in the direction of a trend on a pullback.

Example of RSI Indicator Divergence


The third way that traders look to use the RSI is to identify bullish and bearish changes in the market by watching the RSI line for when it crosses above or below the center line. Although traders will not normally look to trade the crossover it can be used as confirmation for trades based on other methods. As you can see in the chart below, the RSI crossover was a great confirmation of the head and shoulders top, a pattern which we learned about in previous lessons and that occurred recently in the EUR/USD.

Example of the RSI Indicator Centerline Crossover


Links Around the Web to Help You Learn to Trade the Relative Strength (RSI) Indicator

Relative Strength Index (RSI) - StockCharts.com
TradingMarkets | How to use the 2-Period RSI
Trading RSI Divergence

That’s our lesson for today. You should now have a good understanding of the RSI and how traders use this indicator in their trading. In tomorrows lesson we will look at another Oscillator which is known as the Stochastic Oscillator so we hope to see you in that lesson.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and good luck with your trading!

Unregistered

What is the winning % ratio, using RSI as an only indicator for day trading?

David Waring

Hi There,

It would depend on the market and several other variables however I would think that using any indicator just by itself would have a very low winning percentage. Most successful traders from my experience use indicators as one tool in the toolbox.

Hope that helps. If there are any other questions or comments please feel free to post.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

forexer

Hi David,

I've read about failure swings concerning the RSI. I'm not really sure about what that is but it seems quite significant. Can you explain what a failure swing is, and ow to trade it?

Thanks a lot, i really appreciate your reply.

Best regards,
Forexer

David Waring

Hi Forexer,

Glad to hear from you.

Here is a good article which explains RSI Failure Swings:

RSI Failure Swing -- Technical Analysis Education

Hope that helps.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Unregistered

Hi David,

Great tutorials and explanations! Real wealth of knowledge here.

Just wanted to ask whether you knew of a way to trade the RSI using the W and M formations that can appear.

I am looking for some information on these buy and sell signals which centre around certain pattern formations appearing on the rsi namely in the shape of a 'w' or an 'm'.

Can you help in anyway?

Kind Regards,

Dee

David Waring

Hi Dee,

Glad to hear from you and thanks for the compliment I am glad you like the site. I am not very familiar with looking at patterns forming in the RSI outside of Divergence but I did find the below article which talks a bit about this and may be of some help:

RSI Patterns -- Technical Analysis Education

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

ger

Hi Dave Great Site, well done on the videos they are great.
Dave could you give any info on RSI lows, Some sites i have been on consider if an RSI low(rsi hits the 20 line) is put in, the price normally at this level will go lower at some time in the future,also on the upside if an RSI high (rsi hits 80 line) the price at that time will be taken out at some time in the future

Great site and thank you in advance
Ger

David Waring

Hi Ger,

Glad to hear from you.

I don't think I would say if RSI does this then this is going to happen with price however I do think that you can get an indication of what is happening with price right now by looking at the RSI.

If the RSI is high and rising that simply means that the momentum in the market is increasing and vice versa if it is low. With this in mind generally when traders want to try and guage what may happen in the market in the future by looking at the RSI, they will look for something that indicates a change in the current behavior of price that could be indicative of what is about to happen with price in the future.

An example of this would be a divergence where price puts in a higher high for example but the RSI does not. If the market is trading higher in a healthy manner that one would expect to continue then momentum should be increasing into the move. So if the RSI is falling while price is rising, this is indicative that the market may be running out of momentum and may be a good time to exit long trades and potentially enter a short trade depending on what the strategy is that one is trading.

Lastly, as I talk about in many of my lessons, it is important to keep in mind that indicators are just that, they are ment to give you a read on what is happening and a piece of information that you can combine with other things you are seeing to formulate a potential information edge that can be exploited for profit.

Hope that helps.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

taniaye

Hi David:

I tried to applied the strategies learned from you. when i was looking at different time periods the chart tells me something else. 1 day chart gives me a pretty defnite oversold when 1 year chart tells me the price was fair. so how do I decide now. Or what are the other ways to help with that?

Tania