Saturday, September 07, 2013

How to Use the Relative Strength Index

One of the most useful tools employed by many technical commodity traders is a momentum oscillator which measures the velocity of directional price movement.

When prices move up very rapidly, at some point the commodity is considered overbought; when they move down very rapidly, the commodity is considered oversold at some point. In either case, a reaction or reversal is imminent. The slope of the momentum oscillator is directly proportional to the velocity of the move, and the distance traveled up or down by this oscillator is proportional to the magnitude of the move.

The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The vertical axis represents magnitude or distance the indicator moves; the horizontal axis represents time.

Learning to use this index is a lot like learning to read a chart. The more you study the interaction between chart movement and the Relative Strength Index, the more revealing the RSI will become. If used properly, the RSI can be a very valuable tool in interpreting chart movement.

RSI points are plotted daily on a bar chart and, when connected, form the RSI line. Here are some things the index indicates as shown by examples from the following silver chart:

Tops and bottoms - These are often indicated when the index goes above 70 or below 30. The index will usually top out or bottom out before the actual market top or bottom, giving an indication a reversal or at least a significant reaction is imminent.

The major bottom of Aug. 15 was accompanied by an RSI value below 30. The major top of Nov. 9 was preceded by an RSI value above 70. The top made on Jan. 24 was preceded by an RSI value of less than 70. This would indicate this top is less significant than the previous one and either a higher top is in the making or the long-term uptrend is running out of steam.

Chart formations - The index will display graphic chart formations which may not be obvious on a corresponding bar chart. For instance, head-and-shoulders, tops or bottoms, pennants or triangles often show up on the index to indicate breakouts and buy and sell points.

A descending triangle was formed on the RSI chart during October and early November that is not evident on the bar chart. A breakout of this triangle indicates and intermediate move in the direction of the breakout. Note also the long-term coil on the RSI chart with the large number of support points.

Failure swings - Failure swings above 70 or below 30 are very strong indications of a market reversal.
After the RSI exceeded 70 during October, the immediate downswing carried to 65. When this low point of 65 was penetrated the following week, the failure swing was completed.

After the low of Aug. 15, the RSI shot up to 41. After two downswings, this point was penetrated on the upside on Aug. 26, completing the failure swing.

Support and resistance - Areas of support and resistance often show up clearly on the index before becoming apparent on the bar chart. Trendlines on the bar chart often show up as support lines on the RSI. The mid-November break penetrated the uptrend line on the bar chart at the same time as the support level on the RSI chart.

Divergence - Divergence between price action and the RSI is a very strong indicator of a market turning point and is the single most indicative characteristic of the Relative Strength Index. Divergence occurs when the RSI is increasing and price movement is either flat or decreasing. Conversely, divergence occurs when the RSI is decreasing and price movement is either flat or increasing. Divergence does not occur at every turning point.

On the silver chart, there was divergence between the bar chart and RSI at every major turning point. The top made in November was "warned" by the RSI exceeding 70, a failure swing and divergence with the RSI turning sideways while prices continued to climb higher.

Can you pick out the two potential reversals on the RSI indicator?


Throughout May and into early June the RSI signaled an oversold condition, indicating a potential upward turn - which ended up occurring throughout June, July, and into early August.
From mid-September through early November it signaled an overbought condition, indicating a potential downswing - which occurred immediately afterward.
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