RSI ( Relative Strength Indicator )
RSI is one of the easiest technical indicator when it comes to determine market trend after a major crash or major rise. Developed by American mechanical engineer J. Welles Wilder. RSI is a technical indicator that measures the magnitude of price change to analyze market’s overbought and oversold condition.
How does RSI work
RSI has one basic rule of 70-30. When indicator shows above 70 then we consider market overbought. In attached chart i have highlighted RSI at 72.97 when Dow Jones were trading at 25300. Its is clearly in oversold range and RSI indicates a perfect sell around 25300. After selling signal at 25300 it crashed more than 1000 points before entering to oversold zone.
Second rule is 30, When Indicators dips below 30 then its an indication market is in oversold zone. Traders should take a buy when market dip below 30. Below chart is recent Wall Street chart. RSI dip below 30 and it was trading at 27.55 which is clearly indicates oversold market. Those who follow this major indicator must have taken buy near 24000-24100. Market fired nearly 1000 points after that.
RSI= 100-100 / (1+RS)
RS= Avg gain and loss of particular chart.
RSI is a momentum indicator, It cannot be used in deeper technical analysis. Its simplicity is biggest strength and easy to implement. Usually 70-30 rule can be bend according to your needs. You can tweak your analysis into that. I recommend using 28 below when considering oversold and 72.50 above to overbought.
This indicator is widely used by traders, thus making it vulnerable to bots and algorithms. That is why i always recommend notching 1-2 points above and below before considering position following this indicator.
Major drawback of this indicator is its very difficult to calculate the stop loss. Its not a very reliable indicator on short term charts. Long term charts signals range could be very wide. Most of the times traders stuck in position due to false.
How to use RSI in day trading
Unfortunately Relative Strength Index is not a very good day trading indicator, But still many traders and analyst use it. Sometime a big crash could come in intraday or any event which cause 3-4% plunge in market. It could become a very good guide to buy or sell market on those situation.
Its very good in scalping in extreme volatility. Short time frames could be useful while implementing this indicator. I usually recommend to avoid taking position solely base on RSI. I believe it works like a supplement. You need to use another indicators or analysis to start taking position based on this technical indicator. Make sure you apply other indicators to determine the stop loss in every trade.
Sometime during event market would ignore relative strength index and may now show decrease or increase in reading. This happens when extreme volume jumps in market, You may encounter this situation very often. Let me give you an example.
Suppose gold prices are trading at 1300$ and relative index strength reading is 40, Non farm payroll data came and market plunged 18-20$ and reading remain 39-38. This is major situation you may follow while implementing this. Make sure you calculate stop loss before entering any position. Read why you should use stop loss in every trade here.
Hope you enjoyed this article and gained something.
Wishing you happy trading