Ranging Indicators - Oscillators

Relative Strength Index

The RSI is a trend following oscillator that ranges from 0 to 100. It gives an indication of whether a financial product is Overbought or Oversold and therefore can be used as a measure of momentum. This tool is normally used by Day Traders and other Short Term Traders.

When a financial product is in an uptrend the RSI will move upwards towards 100 and the RSI will move towards 0 when there is a downtrend in play. The volatility of the RSI indicator can be controlled by what period a trader uses for the calculation. Popular periods are 9, 14 and 25 day period RSIs. The smaller the period the more volatile the RSI reading will be.

The chart above is an example of a 9 day RSI for the German Dax Index Future. The centre line for the RSI is 50. Above this level implies a bullish phase is taking place as the average gains are greater than the average losses. This is indicated in the chart, the first half of the chart is showing an uptrend in the price action which coincides with a steady increase in the RSI level. As the RSI level breaks through a value of 75, the Dax reaches an Overbought status. This coincides with the uptrend reaching some resistance at 47000 and the price starts to flatten off. Readings below 50 indicate a bearish phase. A centre line crossover indicates a transition from a bullish into a bearish phase and visa versa.

As a basic general rule the RSI will indicate an ´´Overbought´´ situation when it climbs above a value of 70. An ´´Oversold´´ situation occurs when the RSI value drops below 30.  However, The 70/30 levels should be widened when using a more volatile RSI with a shorter time period or when there is a particularly strong bullish or bearish phase in place. Also, RSI tops and bottoms may come before even getting close to either the 70 or 30 levels. A trader has to combine instincts, analysis and other indicators to decipher these changes.

It is important to emphasise the point that an RSI reading of over 70 does not necessarily mean that the market has reached a top and you should take a short position immediately. Like all indicators the RSI should be used in conjunction with a different technical analysis tools, such as a volume based indicator. When used in tandem a trader can get signals that will have more certainty of success.

In contrast to the Moving Average indicators discussed earlier, the RSI is considered to be a leading indicator and can indicate upcoming reversals of a trend. It is therefore a good tool for identifying entry and exit points in a ranging market.

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