Chapter 12, Part V. Relative Strength Index. Page 2

Application of RSI

RSI uses for estimation of oversold and overbought conditions, and I might say that in general it makes better work of this than Stochastic, but still - it’s not perfect, at least not for me.

Chart #1 | EUR/USD Weekly and RSI (9)
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So, here you can see the same chart, as it was with Stochastic. The common approach to RSI is that when it is above 70 (on my chart I use 75) the market is overbought, when it is below 30 (25 on my chart) the market is oversold. RSI stands in these areas for much shorter time and it has given perfect Sell signal, when the market was oversold.

Pipruit: Commander, and what does Overbought or oversold terms mean, in general?​

Commander in Pips: Well, it’s simple. Oversold condition is when there is a high probability that there are no sellers left on the market – sufficient to push the market lower. The same with overbought – there is a high probability that there are insufficient buyers on the market to push it higher. To estimate such conditions, we use different indicators. These conditions do not suggest that the market should definitely reverse, but it should at least turn to a sideways move or see some retracement.

Pipruit: Thanks, I see.​

Commander in Pips: But still RSI is not good for me. And this is all because of it’s scaling in the 0-100 range. The same as with Stochastic – take a look in rectangle again. RSI has reached oversold, but the market has continued its move lower. Even more – during this move RSI has risen! Outstanding! Again, if you’ve taken this “Buy” signal from RSI – you will be really hurt. Due to RSI scaling, that follows from its math – if it reaches, say a value of 15%, but market accelerates down further – it has only 15% left for response to it. That’s why RSI shows poor results during a real thrusting market. This is absolutely unacceptable for us. In the meantime, RSI is simple, so you may experiment with it, maybe you will be able to optimize it according with your personal tasks on the market.

Pipruit: And could we use it for trend identification?​

Commander in Pips: In general, yes. For that purposes we should use 50% border of RSI. If your analysis tells, that may be new uptrend is forming – check RSI. If it stands above 50% - this is a confirmation sign. For downtrend RSI should stand below 50%. According to RSI formula, it tells that during the recent N periods more than the half close-to-close price changes on market were negative. The same is for uptrend – when RSI is above 50% - more than the half of price changes were positive. This gives a bit more confidence with current trend

Pipruit: Thanks. Cool. But when we finally will discuss what we can use for overbought/oversold estimation?​

Commander in Pips: Soon. Now we pass to ADX – Average Directional Move Index, and after that we will return to the topic of overbought/oversold estimation.



P.S. This lesson was written by Sive Morten, who has been working for a large European Bank since April of 2000, and is currently a supervisor of the bank's risk assessment department. Sive's knowledge of forex market and banking industry is vast and quite complete. If you have any specific questions about forex, banking industry, or any other financial instruments, please post themon the next page and Sive should answer soon.


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