With the slow markets yesterday and earlier today, due to Easter holidays in many places (and hence no day trading signal last night/this morning), I thought it would be good to provide a little insight into one of the indicators I use…the RSI.
In the USD/JPY Swing Trade set-up below I mentioned a few things about oscillators – overbought levels etc. I mentioned those because often they are viewed in the wrong way. This article will take a closer at the the RSI indicator and what certain levels can actually tell us about what we are trading. If you are going to use an indicator it is very important to know how that indicator works so you can understand when the information is valuable and when it isn’t.
I am not saying that common ideas about this indicator are wrong, but they need to be used in a context, and not simply used blindly.
RSI is an oscillator and commonly people believe they are only valuable in ranging markets. This is false. An oscillator can give us a lot of information about trends as well.
So here is the first thing we need to know – The RSI moves within ranges during a trend a price. The levels the RSI ranges between can indicate the strength of the trend. In an uptrend the RSI should stay between about 30 and 90. In a down trend it will generally stay between 20 and 70 (often 60). This can let us know if a trend is reversing, as a drop below the 30 level on an RSI is rare in an uptrend. If it ducks below 30 or fails to recover above 70, the uptrend has been stifled. These levels will vary slightly depending on the market traded, so find the levels your market ranges between before using this. (If the market is ranging this information is not particularly useful)
This means if we are in an uptrend we will often have “overbought” type readings on the RSI. Many traders exit positions because they think a price reversal will materialize simply because the RSI is showing a reading of 90 for example. This is not necessarily the case. The RSI looks at average up moves and average down moves, therefore, we can get a drop or reversal in the RSI without a reversal in price. The RSI can move out of this overbought territory even without a significant fall in price. This is because a brief sideways movement will bring down the “up average” calculation of the RSI, allowing it to fall to more normal levels, with price never really moving lower, but simply taking a breather.
An RSI that is continually in the in the 60 to 70 range shows – in a rough approximation – that prices are continually closing near highs and former bar highs a high percentage of the time…and this is great for the person riding the trend. It is true a reversal will eventually occur, but the a trade should not be exited on the single premise that the instrument is “overbought.” Rather we need to look at other factors… is price actually breaking? Is the RSI range still showing strength by staying above 30 and hitting the 80+ range occasionally? Is the RSI making new highs as price makes new highs (this is good)?
Just a few things to consider. The RSI, and oscillators similar to it, can provide a lot more information than they are not commonly given credit for. The above are just a few different ways to look at this indicator. There are many other ways to use this indicator as well. I will cover more of these in future posts.
~Cory Mitchell
Market Strategist
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