What if there was a way to measure the strength of a move up or down using an indicator? Well the RSI is one of the most popular indicators of choice by traders around the world. The term ‘Relative Strength Index’ must not be confused with ‘relative strength’ which is when we compare one stock against another or one sector.
The RSI, like most indicators is the calculation of averages, this is what the calculation looks like.
The average time period we use for the RSI is the 14 period average. Let’s say in the last 14 days, there were 10 up days and 4 down days. We will take the average gain on the 10 days and divide it by 14 – then use the average loss of 4 days and divide it by 14. The RSI index assumes that bulls won on the day the stock closed green (closed up) and bearish when it closes down.
The RSI is used as over bought and over sold indicators, divergences and even centerline crossover. Since the indicator is normalised and bounces between 0 and 100 it can be used to initiate trades using the techniques mentioned above.
The RSI is said to be overbought when over the 80 zone and oversold when under the 40 level. Now one idea to generate a buy signal is to wait for the RSI to dip below 40 and then buy when the RSI breaks above the 40 line. This means that price was significantly oversold and is likely to bounce as the RSI sees strength returning to the market in the form of a move above the 40 area. Here are a few examples of this technique in action on the daily charts!
The chart you see is of the daily timeframe and uses the technique described above. You will notice that the first trade made a very handsome profit and was able to catch the trend. The second and third did not follow through upwards and would have resulted in a loss.
The last, fourth trade was able to catch a 65% gain if one had held on till May 2014.
In this example we can see that several false signals were called during a downtrend and would have resulted in a loss if on had held on. If the exit strategy was to exit at a 4% profit per trade then 3 out of 4 trades would be profitable. In both cases one needed a weapon few traders are able to yield correctly – Patience.