RSI stands for Relative Strength Index and it is one of the most popular oscillators. Before talking
about the relative strength index, I need to spend a couple of words about the oscillators.
What is an oscillator? An oscillator is a technical analysis tool that confines the price between two
extremes: 0 and 100.
So the oscillator uses an algorithm to convert the price on the market into a value that ranges between
0 and 100.
This time I'm not going to analyze the formula to build the relative strength index even if it is not
complicated but I think that I can give you some guidelines to use it, that are much better than the
formula.
The RSI is calculated comparing the gains of the up sessions with the losses of the down sessions over
a given period.
What does this mean in a practical way?
This means that the relative strength index is very sensitive to candlestick movements,
so the bigger the candle, the greater the variation of the RSI line.
Let's see an example on the Meta trader.
We have dollar-Swiss franc on a 30-minute chart and you can see how this candle moves the RSI.
With just one big red candle,
the RSI goes from 56 to 32, 24 points with just one candle.
You can notice that no other candle has such a strong power to move the oscillator in the same way.
So the RSI is very sensitive to candlestick movements.
A big candle can have a huge impact on the calculation of the value. Before checking how to use this
oscillator,
I'm going to share an interesting research about the set up of the RSI.
When you open the oscillator on the meta trader, you can see that the standard set up is "apply to"
and then "close".
In this way the prices that are going to be included in the calculation are the closing prices.
But I want you to think about this: when you have a trend and the price is forming new highs and new
lows,
do you check them on the closing prices or on the shadows?
We check the highs and lows on the shadows not on the real body.
So long time ago I tried to use the RSI in a more logical way or at least more logical to me.
I went beyond the standard setup of this indicator and I decided to apply the RSI to high when there's
an uptrend and to low when there is a downtrend.
Let's check on the Meta trader
how the RSI changes.
Here we have euro-dollar on a daily chart and you can see that there is a clear up trend.
The RSI is calculated on closing prices.
Let's draw a vertical line when we have new highs on the market.
So starting from here, we have the first high here. Then
another one on this green candle. Going on, we have another high on this red candle, then another one
here.
And last one here on this green candle. I zoom in and we can check if the new highs on the chart match
with the new highs on the RSI.
Here we have the first high and the line on the RSI is going down.
So it doesn't match. Here,
the high on the chart matches with the high on the oscillator. Going on,
we have a new high here and the line on the RSI, once again, is going down. Again on this new high.
The same situation. Then, on the last high, the RSI is going up but it doesn't form a high.
You can see that the high is here on the next candle.
Now let's go back and see what changes if we apply the algorithm to highs and not to closes. The first
vertical line matches; the second matches; the same for the third.
The fourth is the same.
The fifth matches once again.
It is far more accurate.
So when you open your RSI, I suggest to leave all the settings like that, a period of 14 candles is
fine but adjust this setting according to the trend on the market.
If there's an uptrend, you will have a better view selecting high. If there is a downtrend, you
will have a better view selecting low.
Having said that, it's time to check how to use this oscillator.
There are two main uses of it.
The first one is as an overbought and oversold indicator.
This is the most common and it is typical of all the oscillators.
When the line approaches the 70 level, we say that the couple is overbought and a down move could start.
When the price approaches the 30 level,
we say that the couple is oversold and an up move could start. This kind of analysis usually works when
the market is in a sideways trend but it's not very useful in situations of strong uptrend or downtrend.
The second way to use this oscillator is as a divergence tool. What is a divergence? A divergence happens
when the oscillator is not giving us the same information of the chart. When the price makes a new high
and the RSI fails to make a concurrent high,
we have a negative divergence, that is a bearish signal. When the price forms a new low,
but the RSI doesn't,
we have a positive divergence,
that is a bullish signal. Here on euro-dollar, daily chart,
we have a down move and I have the RSI applied to lows.
We have a first low here on this candle.
Another low is here on this candle and the last low is on this red candle. On the chart,
we have lower lows,
but if we are going to check the RSI, we can see that the value is increasing at each new low.
This is a positive divergence.
The RSI is telling us the opposite of the chart.
So on these two candles we could consider a long position.
And actually you can see that the price then starts to go up.