cmc markets trading smart series: understanding the rsi
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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.
CMC Markets | Understanding the RSI 3
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.
CMC Markets | Understanding the RSI 4
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
CMC Markets | Understanding the RSI 5
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
CMC Markets | Understanding the RSI 6
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
CMC Markets | Understanding the RSI 7
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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