Today I'm going to discuss one of the most popular indicators for short term trading strategies. Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements.
The RSI indicator was invented by J. Welles Wilder and features RSI in his 1978 book, New Concepts in Technical Trading Systems along with a few other indicators that I will be featuring in the next few weeks.
The RSI oscillates between zero and 100. Traditionally, RSI is considered overbought when above 70 and oversold when below 30.
I will spare explaining the formula to calculate the RSI indicator because the indicator is available on every charting software online and offline so there's no reason to manually calculate anything.
The only thing that needs to be adjusted is the time period. Wilder traditionally used 14 days to calculate the RSI oscillator, while I prefer to use a shorter time period.
I find that the 10 day or 10 bar if you are day trading works very well for short term market swings. So that's the only thing that you will have to change when using this oscillator.
There are many indicators traders use to trade short term trading strategies, most indicators are divided into two areas.
One area is lagging indicators, these are indicators that confirm and follow price action.
A moving average tracks and follows the price trend, it provides information to traders after the fact. Lagging indicators are commonly called trend following because they are designed to get traders in and keep them in as long as the trend is intact.
As such, these indicators are not effective in trading or sideways markets.
Another disadvantage to lagging indicators is because they are lagging, and provide direction after the fact, they may cause you to get into a trend much later and after the initial signal was generated.
However, for trend following they are considered the best indicators for short term trading strategies.
Leading indicators on the other hand are designed to lead price movements, in other words the leading indicator will give a signal before a trend or a reversal has actually occurred. There are some benefits that the leading indicator provides as well. Early signaling for entry and exit is the main upside to using leading indicators.
Leading indicators work best in choppy or trending markets, if used in trending markets it's advised to only use these indicators in the direction of the major trend.
If the market is trending higher, I would only take long trades using the RSI Indicator and if the market is trending downwards, I would only recommend taking trades that are going short.
The best use for Oscillators such as RSI indicator is to measure short term overbought and oversold levels in choppy markets, this is where these indicators thrive.
One of the best ways to use the RSI indicator is to measure for divergences between the market analyzed and the indicator itself.
A bullish divergence occurs when the underlying stock or any other market makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum.
A bearish divergence forms when the stock or other market makes a higher high; and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.
You can get a pretty good idea by looking at these examples how the RSI indicator generates trend reversal signals. The most important thing to remember about using oscillators such as the RSI indicator is the fact that they only work well in range bound or choppy markets.
Markets that are trending typically respond much better to trend following indicators such as the moving average.
Conversely, I don't recommend using a moving average in a choppy market; it's the quickest road to disaster. Make sure to check the general slope or direction of the trend before applying these indicators.
The RSI indicator is one of the most popular indicator traders use for short term trading strategies, I will be doing several more tutorials in the next few weeks, demonstrating how to build a short term trading system with this indicator.
For more on this topic, please go to: Technical Trading Strategies - The Tail Gap Strategy Revisited and Day Trading Indicators - Advance Decline Line
all the best,