Understanding the RSITHE CMC MARKETS TRADING SMART SERIES

CMC Markets | Understanding the RSI 2

‘There is no reason why anyone cannot make a substantial amount of money in the financial markets, but there are many reasons why many people will not. As with most endeavours in life, the key to success is knowledge and action.’

Martin Pring, from Technical Analysis Explained, Fourth Edition, McGraw Hill

Indicators are one of the favourite confirmation tools used by traders and investors. They allow you to garner extra insight as to where shifting trends in momentum may occur and help you make decisions as to when prices may be overbought or oversold. In general, however, indicators can be deceptive in the messages they provide. This is because that while they appear to be extremely simple in the way they’re applied, this actually requires a great deal of care or you could find yourself in a position where your interpretation is greatly mistaken.

As part of our indicators toolkit we cover one of the most popular indicators: the RSI, or Relative Strength Index. We’ll look at how this can help you when you include CFDs in your trading portfolio.

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Relative Strength Index (RSI) This topic will help you:

•• understand•one•of•the•key•indicators•for•any•trader

•• look•for•price•divergence•patterns

•• gain•an•appreciation•for•overbought•and•oversold•levels•as•well•as•their•limitations

The RSI, in use since 1978, is one of a long line of indicators that was

developed by J. Welles Wilder. It has managed to stand the test of

time. To understand why, we need to first look at what this indicator

actually does.

The basic concept of the RSI is that it seeks to show when the

market has run too far one way or the other. Ideally you will apply

this to a trade when the indicator suggests that the direction of

the position is starting to turn and return to a more normal level.

The RSI is one of the family of indicators that can be referred to

as an oscillator. This means that the value oscillates around a mid

point and has two extremities (0 and 100) by which it is bounded.

Depending on how extreme the value is, the more you can tell about

the potential direction of the instrument that you are tracking. In

general usage, an RSI value of more than 70 is considered to be

overbought while a value of less than 30 is considered to be oversold.

For many traders, the use of the words overbought and oversold

can be slightly misleading, because they suggest that once this level

is reached then immediate trading action is required. This is far from

the case, though, and should serve to illustrate how easy it is to be

misled when it comes to technical indicators.

CFDs allow traders to utilise indicators like the RSI in an

all-encompassing fashion due to the ease with which they can be

employed on both the long side (buying with a view to profiting

from a rising price) and the short side (selling with a view to profiting

from a falling price). When using shares, it is realistically possible for

most traders to only deal on the long side.

For you to understand some of the issues surrounding the use of

this indicator, it’s important to understand how it is constructed.

While even the most rudimentary charting package will make the

calculations for you automatically, a look at the formula behind the

indicator can enhance your depth of understanding a great deal. As

you would imagine, this can be of critical importance when you have

capital on the line.

The RSI is calculated as follows:

RSI = 100 – 100/1 + RS, where

RS = average of x days up closes / average of x days down closes

One of the best books written on the subject of technical analysis

is Martin Pring’s very well known Technical Analysis Explained,

which despite its elementary-sounding name is one of the most

comprehensive books on the topic you can get. Pring describes

some of the key features of the RSI very simply:

The formula aims to overcome two problems

involved in the construction of a momentum

indicator: (1) erratic movements and (2) the need

for a constant trading band for comparison

purposes. Erratic movements are caused by

sharp alteration in the values, which are dropped

off in the calculation. For example, in a 20-day rate

of change (ROC) indicator, a sharp decline or

advance 20 days in the past can cause sudden

shifts in the momentum line even if the current

price is little changed. The RSI attempts to smooth

out such distortions.

In the formula employed to create the RSI above, ‘x days’ has been

used as a variable in the equation. This is the point where the trader

chooses how long an average they would like the formula calculated

over. The larger this number the less volatile the RSI indicator will

be, but it will also be slower to respond to market changes. Wilder

himself recommends the use of 14 periods.

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Overbought and oversoldOne of the key features of the RSI indicator is the assistance it can

provide to the trader when it comes to ascertaining if an upward

swing could be about to reverse lower or when a downward swing

may be about to reverse higher. This falls under the broad category

of swing trading, which is primarily concerned with discovering

potential turning points in prices which lead the instrument price in

a new direction. The RSI is limited to levels between 0 and 100. In

standard usage, an instrument is considered to be overbought when

it reaches an RSI value greater than 70 and oversold when it reaches

a level below 30. One thing you need to consider first of all when

using this assessment of where the price is sitting relative to being

overbought or oversold is that just being in these areas on the chart

doesn’t mean that it is time for you to act.

A common way in which traders would suggest that you should use

the RSI indicator is to go long / close short when the RSI goes from

below to above the oversold line, and go short / close long when the

RSI goes from above to below the overbought line. The rationale

is that you are looking for proof of a change in direction actually

occurring prior to acting upon it with your positions. The danger that

traders face if they don’t wait for confirmation is that the RSI can

remain in overbought or oversold territory for an extended period

with no reversal occurring in the price of the underlying instrument.

In fact, in strong trending moves you could suffer significant losses

as the price continues to move against you despite the price being

‘overbought’ or ‘oversold’.

There is some evidence which suggests that even this type of use

of the RSI is not a particularly effective method of trading. This may

then have you question why it is even being referred to.

• Firstly, you should always do your own investigation of

what you find works and doesn’t work.

• Secondly, it is important that you understand weaknesses

that can exist with seemingly standard trading methods

that are widely espoused in trading guides yet may not be

as effective as you might have anticipated.

This isn’t to suggest that RSI is totally ineffective but, unfortunately,

you won’t be profitable simply by following the ‘overbought’ and

‘oversold’ rules that described above.

When you look at the chart below, you can see that there is quite

significant oscillation of the RSI over its duration. In the window

displaying the RSI there are two blue lines shown at the point

70 (overbought) and the point 30 (oversold). You can see that in

the majority of instances the RSI trades inside the range of the

overbought and the oversold lines – it is only really when it goes

outside these that it starts to get quite interesting.

The RSI in action

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Using a closer view, you can see that the RSI has moved from above

to below the overbought line in this chart. The 5- and the 15-period

moving averages have been placed on this chart so you can see

another tool for working on entry points for instruments having a

change of direction. You can see at point 1, where the RSI completed

its formation, that the CFD trader would have used this as a basis

for a short trade and it would have been successful. Interestingly

in this case, you can see that the share price fell into the oversold

level and this gave the trader an opportunity to then go long on the

instrument.

In the illustration below, you can see that an instrument which is

trending strongly can push the RSI to the extremities and hold them

there for a relatively long time. When you look closely, you can see

that taking short positions on this company each time the RSI moved

from above to below the overbought line would have been very

unprofitable overall. This means that instruments trading in a very

strong trend are likely to be poor trading opportunities if using the

RSI as your sole means of determining your entry and exit.

Using the RSI with other tools

Beware of the RSI in strong trends

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Happily, however, there is a lot more to the RSI than simply

classifying it as either overbought and oversold and acting

accordingly. One of the most remarkable things about this particular

indicator is that you can apply other common technical indicators

to it and then use those results to help you make your trading

decisions. Of particular note is the ability to use pattern recognition

techniques which include patterns like triangles as well as basic

support and resistance methodologies.

In our pattern recognition guide, Tell-tale Trading Patterns, we

investigate the use of triangles as part of your trading, so if you

need to review this it is well worth downloading this guide to find

out more. Rather than rehash the same material, we will present

some examples so you can see how this will work.

RSI divergenceIn many cases you’ll find that the RSI follows the general direction

of the price, by which you will see that as the price rises and falls the

value of the indicator will also rise and fall. However, when you start

looking closely you will see that sometimes there is a difference

in the way the indicator moves relative to the price. This is known

as divergence. Generally, divergence will show itself most clearly

when prices are marking a series of higher/lower peaks/troughs

but the RSI is not. This may be a very good sign that the prevailing

momentum of the price is dissipating and a reversal may be

imminent. This would see you then tighten your stops and/or look

for an opportunity to set up a trade on the short side of the market.

As with just about any type of trading you engage in, you need to be

mindful of the prevailing trend direction. In the short term, it may be

okay to take a trade that is against the prevailing trend, but if the

market is moving clearly in one direction, then taking trades in the

opposite direction may prove to be quite low probability.

As you can see in the example below, the RSI travels in broadly the

same direction as the share price (ASX code: ASX) most of the time.

What becomes clear as you look closer is that sometimes there are

distinct differences in the way the two travel.

Divergence in action

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The RSI can form ‘patterns’ too

In the chart above, there are two points of interest. One is the

divergence and the other is the ascending triangle that is formed.

Let’s look at each of these in turn.

First of all, take a look at the divergence setup. As you can see when

looking at the price candles, there is a lower trough formed and then

a further lower trough formed subsequently. If you look at the point

on the RSI indicator directly below each of these troughs you can see

a lower trough occur, but it is followed by a higher trough afterwards.

Essentially, when the price and the RSI don’t match up you have

divergence. Whether or not this is something you can trade, however,

requires more testing.

The formation below is interesting because, as you can see, when

the RSI starts to diverge from the movements of the price it begins

to form into what would eventually be a confirmed ascending

triangle. This is a breakout formation, which means that when the

RSI breaks through the resistance level (shown on the chart) this is

a very bullish signal. It would encourage the trader to go long at this

time.

Review • You should understand the key component of the RSI

and recognise how to apply the indicator to determine

potentially overbought and oversold levels.

• You should understand the powerful concept of

divergence and how this can be a leading indicator of turning

points in the price of the instrument.

• You should recognise that patterns can occur in the RSI and be

able to apply them to trades accordingly.

Breakouts are of interest to many traders

© CMC Markets Singapore Pte. Ltd., Reg. No./UEN 200605050E. All rights reserved August 2011.

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