Part V. Relative Strength Index. Commander in Pips: The next indicator that we will talk about is “Relative Strength Index”, also known as RSI. This indicator has many features in common with Stochastic, but is even simpler, because it consists of just a single line. This indicator is also scaled in the range of 0-100%. The major purpose of this indicator, at least how traders apply it – is for estimation of Overbought/oversold conditions. RSI also has adjustable extreme areas – below 30% and above 70%. But you can appoint any area that you want – say, 25/75 or 15/85 etc. Pipruit: Ok, I see, and what the difference with Stochastic then, except the visual appearance? Commander in Pips: It has different math as a basis for how it works. It makes RSI more suitable for estimating overbought/oversold conditions. If you do not want to learn the math of RSI – you can skip it. If you want to know it, then look: RSI = 100-(100/(1+RS)), where RS = UpC/DownC; UpC = moving average of n-period gains; DownC = absolute value (that is, ignoring sign) of the smoothed moving average of n-period losses; Pipruit: Well, sounds too complicated… Commander in Pips: I see, let’s look how it works on simple example then: Assume that we calculate 14-period RSI. And during this 14 periods price has changed as follows, compares to preceding trading session, in pips: -0.0037, +0.0015, +0.0068, -0.0092, +0.0069,- 0.0029, -0.0001, +0.0060, +0.0056, -0.0031, +0.0029, -0.0009, -0.0001, +0.0023. So, we have 14 numbers for our calculation… Pipruit: Wow, wow, wait a minute Commander. Say, what does -0.0037 pips mean, in the beginning? Commander in Pips: It means that in this day (and it was 14 days ago) close price has declined from the previous close for 37 pips. On the next day it has closed 15 pips higher, on the next day 68 pips higher, and so on, until we will come to today trading session that has closed 23 pips higher, then yesterday’s one. Is it clear? Pipruit: Oh, yes. Now it is… Commander in Pips: Now we should split these numbers into two groups: one group should contain only upward changes, while another one only downward changes during recent 14 trading sessions: Upward changes: 0; +0.0015; +0.0068; 0; +0.0069; 0; 0; +0.0060; +0.0056; 0; +0.0029; 0; 0; +0.0023 Downward changes: -0.0037; 0; 0; -0.0092; 0; -0.0029; -0.0001; 0; 0; -0.0031; 0; -0.009; -0.0001; 0. Pipruit: And where do you find so many zeros in our array? Commander in Pips: Nowhere. The point is that each array should have 14 numbers, but periods with opposite change replace by zero. For instance – see, the first change -0.0037, it negative and you can see it only in downward array. But it replaced by zero in upward array. The same is for any negative number – it replaced by zero in upward array. In downward array each positive number, in turn, is replaced by zero also. Pipruit: Oh, I’ve got it, and what then? Commander in Pips: Now we should calculate average value of each array. I hope you remember how to do that, so this is task for you. But we have to apply absolute changes – don’t pay attention to “+” or “-". Pipruit: Ok, That’s simple: Upward changes average = Sum (0; +0.0015; +0.0068; 0; +0.0069; 0; 0; +0.0060; +0.0056; 0; +0.0029; 0; 0; +0.0023)/14 = 0.0320/14 = 22.86 pips Downward changes = Sum (-0.0037; 0; 0; -0.0092; 0; -0.0029; -0.0001; 0; 0; -0.0031; 0; -0.009; -0.0001; 0) = -0.0200/14=-14.29 pips. But, since we need absolute value, so it will be just 14.29 Commander in Pips: Great. These values are our UpC and DownC. Now you can get RSI number – just put that you’ve calculated in RSI formula. Pipruit: Cool! With pleasure: So, RS=22.86/14.29 = 1.6 RSI = 100-(100/(1+1.6))=61.54 Excellent! But, Commander, how to estimate a new value of RSI when a new closing price will appear? Commander in Pips: Here you can apply two different approaches – calculate the value using exponential averaging method, or simple method. The most common and initial (W. Wilder – creator of RSI) method is exponential. Assume that price was rising during the new trading session for 19 pips. Then, using the exponential way of averaging is done like this: upC=((13 х 22.86)+19)/14=22.58 downC=((13 х 14.26)+0)/14=13.24 RS=22.58/13.24=1.7 RSI=100 - (100/(1+1.7))=63 If you will apply simple averaging method (Cutler RSI), then you will get a bit different number: upC=(15+68+0+69+0+0+60+56+0+29+0+0+23+19)/14=24.21 downC=(0+0+92+0+29+1+0+0+31+0+9+1+0+0)/14=11.64 RS=24.21/11.64=2.1 RSI=100 - (100/(1+2.1))=68 First, the exponential method is the traditional one, and most software programs use this particular method. Anyway, as with moving averages, it’s impossible to say which one is better, because it’s very personal. You will have to estimate it for yourself by exploring RSI. Now, let’s look how it works.