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In this age of computers and technical trading software, Welles Wilder’s Relative Strength Index (RSI) remains one of the most popular indicators in technical analysis.
The Relative Strength Indicator measures gains against falls over a given period and ascribes a value between 1 and 100. Period settings of 14 and 21 are among the most popular.
Most of us start learning about the Relative Strength Indicator in terms of overbought and oversold levels. As illustrated in Chart 1 below, the standard interpretation is that readings above 70 indicate an overbought market and readings below 30 an oversold market.
Chart 1 – IBM Daily Bar Chart
click chart for more detail
As you can see, however, these readings can be misleading when the stock remains overbought or oversold for an extended period. This is typical of momentum oscillators. You can counteract this by comparing the RSIs current levels to its previous levels at significant points on the chart.
Many of you will be familiar with the concept of RSI divergence, especially as a filter for Wave 5 Trades. This was discussed last year in the Trading Tutors Article, Using Divergence. You compare the RSI readings at significant turning points and look for a difference in behaviour between price action and the RSI.
Similarly, we can compare the RSI readings of significant highs or lows during a trend to look for support or resistance levels. Chart 2 shows a Wave 4 style retracement trade. Note that while the lows on the stock are at different price levels they are at very similar RSI levels.
Chart 2 – HURN Daily Bar Chart
click chart for more detail
This kind of pattern can help us judge whether a retracement is over or still has some distance to run. The RSI tells us that while the turning points (or potential turning points) are at different price levels, they show a similar pattern in terms of the market’s overall progression.
RSI support and resistance are another measure of retracement strength and can be especially useful for those who trade Wave 4 Buy and Sell set-ups.
Happy Trading
Jordan Craw
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