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program. They disclaim any warranties (express or implied),
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including but not limited to special, incidental, consequential, or other
damages. As always, the advice of a competent professional should be
sought where necessary.
Why RSI?
RSI stands for Relative Strength Index; however the name does not
adequately describe what the indicator does. It does not really
measure the “relative strength” of anything; rather the indicator gives
you an idea as to the internal pressures affecting a market.
In other words, RSI can help you get a “feel” for what other traders
are thinking.
RSI is also useful because it mimics what other indicators are telling
you as well…and more.
Here is a chart of RSI with Slow Stochastics overlaid. Notice that both
indicators rely on overbought and oversold regions to give you a
sense for where the market is currently trading.
Notice how the circles identify where both indicators would have
given buy and sell signals; although the signals may have been
generated differently (more on that in a minute). Here you can see
that RSI and Stochastics follow each other pretty closely.
RSI is actually a little more sensitive than MACD and will give buy/sell
signals earlier.
As you can see from the chart, MOM and RSI follow each other pretty
well. In fact, MOM seems to fill in under the RSI line. This is helpful to
remember when you are looking at RSI: that the space between the
RSI and the 50% level on the RSI indicator, will roughly approximate
the market momentum.
So you can see how you can use RSI to gather the same information
that is given on different indicators, but there is more. RSI lends itself
particularly well to the support and resistance trader because it helps
us identify important support and resistance levels.
Always remember and never forget RSI, like any secondary indicator,
is usually a lagging indicator. This means that it normally follows
what is happening on the price chart.
RSI Settings
If you are curious I encourage you to try the different settings and find
one that is right for you. I used to use a 21 period average before;
however I went back to the 14 period as I found it just as predictable.
This is not as important for our purposes since we will be using more
than just the overbought and oversold levels in our analysis, but here
too, feel free to experiment. You may find that the more extreme
levels are to your liking.
Notice how the RSI indicator is following prices down. Note too how
the peaks, highlighted by the dotted vertical lines, mirror the peaks on
the price chart.
RSI shows that while prices continued lower, RSI (or the market
sentiment) was rejecting going lower. In fact as the market was
approaching the oversold region around the beginning of June, RSI
was starting to head slightly higher.
Now RSI shows that the market is either ready to break the
downtrend or rebound off the trendline and continue lower still.
Well, given what we have learned from the RSI chart we know that
the current price is the “test point” price. Therefore we have one of
two options:
1. either prices will bounce off the RSI trendline and continue
lower through support, or
2. prices will bounce off support and break the RSI trendline
heading higher.
When you take that into consideration that the market is near the
oversold region and seems to be rejecting going lower, as well as the
substantial support just below the market at the 618 area, it seems
reasonable to assume that RSI will break the descending trendline
and prices will head higher.
Therefore you could plan your trade to enter the market long above
the high of the last day. This means that if prices do not rally off
support and instead head lower, then your order will not be engaged
and you will suffer no loss.
Notice that the market did exactly as we expected and broke through
the RSI trendline, which is shown as a dotted line in this chart. The
original test point is still highlighted by the yellow circle on the RSI
and price charts.
As the market advanced for the next few weeks, notice how RSI
formed a channel in the process. This is my second favourite tool to
use on the RSI chart.
So now that we know that the market is nearing another “test point”
we can look to the price chart to try and determine where that might
be. There are two significant resistance areas above the 721 region
which may coincide with the RSI test point: 740 and 755 (not
highlighted).
We also know that the market is getting into overbought territory and
will be quite severely overbought if it reaches the white circle;
therefore we might expect the market to reverse from here and send
prices lower.
Notice how the market continued higher and found the 740 resistance
area, but what happened to RSI?
RSI did not follow suit. Rather RSI began moving in the opposite to
prices as shown in the shaded pink area of the price chart. This is
DIVERGENCE and is one of the strongest signals you can get from
RSI.
When RSI and prices begin moving in opposite directions for a period
of time keep a close watch on the market because you are almost
guaranteed a change in direction!
Now I know some of you are asking about the breakout that occurred
near the end of July and is shown by the black arrow. On this day the
market breached the lower RSI trendline which might have hinted of a
change in trend.
Look at what happened the day after the black arrow however. While
it appears that the market got below the low of the previous day, it is
in fact only 2 ticks lower. You know from Appendix A in the manual
that 2 ticks in sugar is close enough to be resistance; therefore our
entry order would have been at least 3 ticks away to make sure the
market did not get snagged by resistance, which is exactly what
happened here.
This is why it is important that you try to make the market come to
you before it engages your order. It is a simple way to reduce the
possibility of “whipsaws” in your trades.
As you can see RSI rebounded after the breaking of the trendline and
prices continued higher to resistance at 740. Notice how the market
reacted to the 740 level by retreating slightly the next day (last bar on
chart)? Notice too how RSI is still showing divergence and is about to
leave the overbought area of the indicator?
These are two very strong sell signals. In light of this you could plan
to enter below the low of the last day, allowing at least 3 ticks below
the low, with reasonable confidence that the market will continue
lower.
Here is the market a couple of days later. Note how the market found
the 50% profit target in only one session! That is a fast market, even
for sugar.
The best part is that you could have taken multiple contracts with
confidence in a trade like this since RSI and resistance were both
strongly suggesting that prices would come down. By placing exit
stops above the high of the previous day you would have had only
$125 risk per contract and would have profited nearly $500 per
contract for a risk/reward ratio of 4:1.
One other point I want you to notice from this chart is that RSI has a
tendency to “hook” at important support and resistance levels. This
can aid you in identifying when the market might pause or stop and
reverse direction.
Early Signals
In this chart you can clearly see how RSI has already broken the
trendline while prices still remain in a channel formation. Knowing this
you would give preference to a breakout below the channel,
especially when the breakout is as substantial as this one.
Likewise, knowing that RSI has already dipped lower, you could enter
the market short below the low of the last day instead of below the
bottom of the channel. This would enable you to both get into the
market at a better price and have less money at risk.
One last point to bear in mind when dealing with the overbought and
oversold regions on the indicator, is that the market does not have to
reverse simply because the market is overbought or oversold.
Sometimes the market can spend several days or even weeks in the
overbought or oversold region and all that time prices can continue to
go higher or lower.
In this chart you can see that Live Cattle spent the better part of July
and some of August in the overbought region of the RSI indicator.
During this time prices kept on advancing without any significant
retracement in price.
In this chart the indicator has broken below the 2 point which would
lead you to believe that a short position is in order. You could initiate
such a position by placing a sell order below the current low and
enter short only if the market was able to exceed the low.
Final Thoughts
When using RSI remember that it rarely makes a straight line from
overbought to oversold. Expect the indicator to hook and use these
hooks to draw trendlines and channels to help give you clues as to
what might happen next.