By Sylvain Vervoort – In this article I will talk about the Relative Strength Indicator used as a leading indicator to show early price reversals. We will also look at the creation of a dynamic overbought and oversold level and the use of small M-and-W patterns, leading short term price reversals.
The Relative Strength Index (RSI) is a popular momentum oscillator. Momentum refers to the speed of change; oscillator means that the value of the RSI oscillates between two values (here 0 and 100). The RSI was introduced in 1978 by J. Welles Wilder. RSI measures the relation between the price bars with a higher closing price compared to the previous bar, and between the bars with a lower closing price compared to the previous price bar, over a given time period.
Originally, Wilder used a 14-days period on daily charts; this remains the standard and most widely used value today. The RSI is a leading indicator where tops and bottoms will be visible in the RSI before they show up on the price chart.
The standard 14-period RSI makes tops above 70, called the overbought area; when it bottoms below 30, it is called the oversold area. Many times new tops and bottoms show up in the RSI before they are visible on the price chart; however, a continuing uptrend or downtrend will keep the RSI in the overbought or oversold zone. The RSI indicator can be used as part of the decision making process to open or close a position. Divergence signals between price and RSI are a trade confirmation, preferably together with other technical buy or sell signals. On the other hand, an RSI continuing to move within the overbought or oversold area can help you to hold on to an open position when other selling signals appear, that way avoiding unnecessary closing of a position.
Looking at the lows of the oscillator and comparing them with the lows in price, you can see 3 different situations:
When the price and oscillator make higher or equal bottoms, they converge. Until there is no other indication, the most probable price move is a continuation of the uptrend. When the oscillator creates a higher bottom while the price makes a lower bottom, they diverge. This is mostly found at the end of a downtrend, indicating an uptrend reversal. When the oscillator has a lower bottom while the price sets a higher bottom, they diverge. This is mostly found in a price uptrend after a price correction, indicating a continuation of the uptrend.
Looking at the highs of the oscillator and comparing them with highs in price, you can see 3 other situations:
When the price and the oscillator make equal or lower tops, they converge. Until there is no other indication, the most probable price move is a continuation of the downtrend. When the oscillator makes a lower top while price makes a higher top, they diverge. This is mostly found at the end of an uptrend, indicating a downtrend reversal. When the oscillator makes a higher top while price makes a lower top, they diverge. This is usually found in a price downtrend after a price up correction, indicating a continuation of the downtrend.
A divergence with a higher bottom in the RSI indicator and a lower bottom on the price chart is an indication for an uptrend reversal. On the other hand, a divergence with a higher top in the price chart and a lower top in the RSI indicator points to a downtrend reversal.
A hidden or inverse divergence with a lower bottom in the RSI and a higher bottom in price is most common found in an uptrend. There is normally not yet a divergence between the previous tops. The down correction is apparently just an intermediate correction for the previous uptrend. This hidden divergent move points in the direction of a continuation of the previous uptrend. You can use the divergent turning point as a price support level.
A hidden or inverse divergence with a higher top in the RSI and a lower top in price is most common found in a downtrend. There is mostly not yet a divergence between the previous bottoms. The up correction is apparently just an intermediate correction for the previous downtrend. This hidden divergent move points in the direction of a continuation of the previous downtrend. You can use the divergent turning point as a price resistance level.
The 30-70 fixed reference level used in the standard RSI is a disadvantage if you are using time periods other than the standard 14 bars. Using for example a 30-day RSI will show that the 30 and 70 levels are not reached anymore.
You can solve this by using a variable reference level. A simple way of achieving this is by using a standard-deviation value referenced to the median RSI 50 level in a predefined look-back period. You can setup the upper standard deviation to a value of 50 plus 1.5 times the standard deviation over a 100-day look-back period of the closing prices. That way with larger RSI time periods the reference level will move closer to the 50 level in the order 40 to 60, whereas for smaller period’s reference levels move farther away to the 20 and 80 levels. It is now easier to recognize overbought or oversold conditions with ANY RSI time period.
Small M-and-W shaped patterns are short time patterns visible in the overbought and oversold areas, or around the 50-reference of the RSI indicator. Small M-shaped patterns at the top and small W-shaped patterns at the bottom give reliable short-term price reversal signals. Preferably, they’ll incline in the direction of the reversal. The second leg of the M-shaped pattern does not move above the first leg. The second leg of the W-shaped pattern does not move below the first leg. M and W patterns are unrelated to convergences or divergences between the price and RSI indicator. They are more useful when there is a convergent move because they are at that moment in time, the only visible indicators of, at least, a short-term reversal.
The RSI indicator is most useful to detect price trend reversals based on normal or hidden divergences and using the M-and-W short term patterns in case of convergent price moves. Overbought and oversold areas can best be detected with an active standard deviation band. This setup is certainly one of the indicators that will help you to make better trading decisions.
About the Author
Want to learn more and see some examples about the use of the RSI? You can find a lot of learning material about basic technical analysis techniques for free at my website: http://stocata.org. Sylvain Vervoort is a trader and author with regular contributions in Stocks & Commodities magazine.