Trading the Sensex with the RSI
Very basically, when trading the stock markets "buy" signals on the RSI are considered to be readings of 30 or less (the security is considered oversold) and "sell" signals are considered to be RSI values of 70 or greater (the security is considered overbought). Depending on the technician and price volatility, there are various other qualifiers and nuances that can be incorporated into a signal.
First Some History Relative Strength Index was developed by J.Welles Wilder Jr. and first introduced in his book 'New Concepts In Technical Trading Systems'. It is one of the most popular technical tools around and is plotted on a vertical scale of 0 to 100. The 70% and 30% levels are used as warning signals. A relative strength index above 70% is considered overbought and below 30% is considered oversold.
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An RSI above 70% is considered overbought and below 30% is considered oversold.
An overbought or oversold condition merely indicates that there is a high probability of a counter reaction. It is an indication that there may be an opportunity to buy or sell, but does not provide the final signal. RSI signals should always be used in conjunction with trend-reversal signals offered by the price itself.
Calculation
Relative Strength Index (RSI) measures the strength of all upward movement against the strength of all downward movement in a specified time frame.
The mathematical formula for RSI is shown below:
RSI = 100 - [100/(1+RS)]
RS = average of n day's up closes / average of n day's down closes
The most common parameter for RSI is period 14, although users can pick their favorite period of time if they wish. It is one of the most popular oscillators that works well in range-bound market.
Signals
Tops and Bottoms
These are indicated when the readings go above 70 (top) and below 30 (bottom). RSI can form formations similar to Chart Formations. The RSI may form chart formations that may or may not appear on the actual bar chart e.g. you might see a head and shoulders formation on the RSI but not on the bar chart.
Failure Swings
When the RSI goes above 70 or below 30 this is a strong indication that
the market is ready for a reversal.
Support and Resistance
It is sometimes more apparent that support or resistance is forming in
the RSI than can be seen on the bar chart.
Our Use Of RSI
Our favorite use of RSI is that of divergence as suggested by Wilder himself.. When the security you are trading makes a new high and the RSI turns down that is bearish divergence.
The same is true of bullish divergence. When price makes a new low (red line) and the RSI turns up (blue line) that is bullish divergence as in the 30 min chart of the BSE Sensex shown below:
We also prefer to see divergence at major tops and bottoms. That is to say, if we have been in a down trend for some time as shown in the chart above and price has gone past a reading of 20 on the RSI AND we see divergence then we are a lot more confident that price has in fact bottomed. We don't like to use RSI as a sole trigger for a new position but rather like to use it in combination with other indicators to help build a picture. |
You will notice that in most cases of divergence the security makes a low as does the RSI, then the RSI begins to turn up but the security continues down.
We wait for the
security to make a new low and the RSI to come down but not as low as
the previous low and that is the point where action can be taken. The
fact that the RSI has not dropped lower than its previous low and the
price has, is the point of recognition.
If we also have a break of a trendline or it has reach a projection or some other confirming analysis then we would enter a trade. For the purposes of this illustration we will use a break of a trendline to confirm that trend direction has indeed changed.
Have a look at the 30
min chart below of the BSE Sensex:
In the chart above we have the perfect set up as the market showed oversold conditions and divergence on the RSI, price came back up and broke our trendline (orange line) at which stage we would have placed our entry to go long the market.
Advanced
A more advanced method is to
use Bollinger Bands for your target and exit strategy after your entry.
Below is a 30min chart of the BSE Sensex with RSI set
at 14, and Bollinger Bands set at 20.
Trading Rules (Going long):
- Identify divergence between the security and RSI.
- Confirm oversold conditions with a reading below 20 on the RSI.
- Draw a trendline (orange line) and enter when price breaks the trendline (Point A).
- Exit when price retraces back to the middle Bollinger Band line (Point B).
- Your stop loss will be whenever price hits the lower Bollinger Band line after your entry.
Conclusion
- The RSI is a momentum indicator, or oscillator, that measures the relative internal strength of a market (not against another market or index).
- As with all oscillators, RSI can provide early warning signals but should be used in conjunction with other indicators.
- Divergences are the most important signal provided by RSI.
Thank you for joining us in this stock trading lesson.
The Indiadaytrading Team
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Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument.