Relative Strength Index
The relative strength index (RSI) is an instrument in technical analysis that is used when studying graphs. It is similar to the stochastic oscillator and is useful in identifying buy and sell signals.
The “standard” period used with the RSI is 14, but it can be set according to personal preference.
Increasing the number of periods will give you a less responsive indicator with less accentuated curves. Conversely, setting the amount of periods to a lower figure will provide for a more reactive RSI on the graph. It is not advised to use a figure too high or too low however, as this will increase the number of false positives.
The RSI appears on a graph as a line that oscillates between the values of 0 and 100:
Between these figures we have two important zones, identified as the zone above 70 and the zone below 30.
Why are these two areas important? They are important because below 30 we can be sure that the trading of our cross is in a situation of oversold, while over 70 would signal that the cross is overbought.
Each time the line of this indicator reaches the zone of overbought, or declines down to the zone of oversold, it is possibile that an inversion or a price correction will occur.
In a similar way, the central line, defined at 50, is useful for understanding the prevailing direction of the cross, according to whether the line oscillates from the bottom upwards or viceversa.
The median line of 50 is considered to be the dividing point between an upward moving or bullish market and a downward moving or bearish market.
One method that can be used to give more certainty of an imminent inversion is that of identifying a difference between the direction of the candlestick chart and the oscillator. Another way is to apply a moving average, as described below.
Trading Method using RSI + Moving Average
Unfortunately, situations of overbought and oversold are not always synonymous with inversion. Often our instinct leads us to make a hasty decision to sell at overbought because we are sure that the trend could undergo a change of direction.
While this is true, it is impossible to know exactly when the change will occur. A situation of overbought could last days or weeks and so we can lose precious money by going against the direction of the cross.
To give yourself an even greater advantage you can use a popular technique that consists of applying the RSI in combination with a moving average.
Moving Average + RSI
This is where a moving average is applied to the relative strength index. The technique consists of finding the points of entry and the points of exit where the moving average and the RSI intersect.
When the RSI intersects the moving average in a downward movement, our cross loses value, and it is advisable to open a short position. On the contrary, when the moving average is intersected in an upwards direction, the cross goes up in price and indicates the moment to go long.
Bullish divergence occurs when the indicator tends to rise, while price moves downward. Similarly, if the indicator shows the lower highs while the price action makes us see a rising price, we are facing a Bearish divergence.
Let’s see two examples to get up and running . at the first we see Aussie on the hourly chart (AUD / USD), in the upper part of the figure, the price shows a bullish trend, as evidenced by the line joining the top of the candles.
At the bottom, however, the RSI is telling us that compared to the past observation period, the upward movement of prices is losing strength, forming a bearish divergence and presenting the input signal.
We remain in the field of currency and let’s observe another hourly chart, the bullish divergence is quite clear, we see a price that continues its downward trend, while the oscillator draws the higher lows, showing the trader the bullish divergence and signal purchase.
RSI Divergence already formed on the chart. To take a short position, we need to something more like a support breakout that occurs after the RSI divergence, or a strong candlestick patterns as a strong Bearish Engulfing or Dark Cloud Cover.