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These days, there are hundreds, and probably thousands, of indicators and oscillators, especially if you count the many indicators that have been developed solely for personal use. We will strictly limit the overview here to indicators used by myself.
The RSI indicator I use as part of the decision process to open or close a position. Divergence signals between price and RSI are a trade confirmation when other buy or sell signals are present. On the other hand, an overbought or oversold RSI can help to hold on to the position when selling signals appear, that way avoiding unnecessary closing of the position.
I use a standard RSI with a dynamic reference level.
The Relative Strength Index (RSI) is a popular momentum oscillator. Momentum refers to the speed of change; oscillator means that the value of the RSI moves (oscillates) between two values (0 and 100). The RSI was introduced by J. Welles Wilder in New Concepts in Technical Trading Systems.
The term “relative strength” might sound a little confusing because it does not compare the relative strength between stocks; rather, it compares the actual price with past prices.
For the application and estimation of price evolution I primarily look at divergences between the RSI and the price bars.
U = Averaged sum of the prices when the closing price was higher (compared to the previous bar) in the period used.
D = Averaged sum of the prices when the closing price was lower (compared to the previous bar) in the period used.
Within the time period used, RSI measures the relation between the price bars with a higher closing price compared to the previous bar, and between the bars with a lower closing price compared to the previous price bar.
Originally, Wilder used a 14-day period on daily charts; this remains the standard and most widely used value today.
The RSI is a leading indicator.
Tops and bottoms will be visible in the RSI before they show on the price chart.
Figure 5.1: RSI divergences and overbought and oversold areas.
The standard 14-period RSI makes tops above 70 and is called the overbought area; when it bottoms below 30, it is called the oversold area (figure 5.1).
These tops and bottoms show up in the RSI before there are tops or bottoms visible on the price chart; however, a continuing uptrend or downtrend will keep the RSI in the overbought or oversold zone.
When tops or bottoms of a stock price and an oscillator move in the same direction it’s known as convergence. When price and oscillator tops or bottoms move in opposite directions, it’s known as a divergence.
Figure 5.2: Basic bottom convergence and divergence.
In looking at the lows of the oscillator and comparing them with the lows in price, we can define three different situations (see figure 5.2):
Simply looking at bottoms, we can say that the price is going to move up if there is a divergence between the price and the oscillator or if the price and the oscillator bottoms converge in an uptrend.
Figure 5.3: Basic top convergence and divergence.
Looking at the highs of the oscillator and comparing them with highs in price, we can define three other situations (see Figure 5.3):
Just by looking at the tops, you can say that the price will move down if there is a divergence between the price and the oscillator or if the price and the oscillator tops converge in a downtrend.
Divergences are reliable indications for predicting trend reversals.
A divergence with a higher bottom in the RSI indicator and a lower bottom on the price chart is an indicator for an uptrend reversal . On the other hand, a divergence with a higher top in the price chart and a lower top in the RSI indicator points to a downtrend reversal (figure 5.1).
Figure 5.4: Inverse divergence with a higher top in the RSI and a lower top in price.
Figure 5.4 is an inverse divergence with a higher top in the RSI and a lower top in price. This is most common in a downtrend when there is a temporary up-correction in that downtrend, and the price is making a lower top while the RSI is making a higher top. This is an indication that the price is reversing and will continue the previous downtrend.
Figure 5.5: Inverse divergence with lower RSI bottom and a higher or equal price bottom.
Figure 5.5 shows an inverse divergence with a lower RSI bottom and a higher or equal price bottom. It is more common in an uptrend when temporary downward corrections end with a higher price bottom while having a lower bottom in the RSI.
This is a signal that the price is reversing and will continue the previous uptrend.