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Technical Analysis training course learning video part11 about the RSI stock indicator or Relative Strength Index from Welles Wilder which is a momentum oscillator. Looking at overbought and oversold areas and detecting convergences and divergences with price. Including hidden divergence, a dynamic reference level, and M and W shaped reversal patterns.
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Hello! Sylvain Vervoort here with technical analysis part 11. We will have a look at the RSI indicator and how it can be used to detect price reversals. Pay a visit to my website at stocata dot org and have a look at my new book “Capturing Profit with Technical Analysis”. The purpose of this video series is to teach you how to trade successfully applying technical analysis techniques.
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 oscillates between two values (here 0 and 100). The RSI was introduced in 1978 by J. Welles Wilder. The term “relative strength” might sound a little confusing because it does not compare the relative strength between stocks; rather, it compares the up and down price moves over a past period.
This is the basic RSI formula:
U = Averaged sum of the prices when the closing price was higher compared to the previous bar in the used period.
D = Averaged sum of the prices when the closing price was lower compared to the previous bar in the 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, in a set time period.
Originally, Wilder used a 14-days period on daily charts; this remains the standard and most widely used value today. The RSI is a leading indicator. As you can see on this chart, tops and bottoms will be visible in the RSI before they show up on the price chart.
The standard 14-period RSI makes tops above 70, called the overbought area; when it bottoms below 30, it is called the oversold area. Many times new tops and bottoms show up in the RSI before they are visible on the price chart; however, a continuing uptrend or downtrend will keep the RSI in the overbought or oversold zone. The RSI indicator can be used as part of the decision making process to open or close a position. Divergence signals between price and RSI as visible in this chart are a trade confirmation preferably together with other technical buy or sell signals. On the other hand, an RSI continuing to move within the overbought or oversold area can help you to hold on to an open position when other selling signals appear, that way avoiding unnecessary closing of a position.
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. Looking at the lows of the oscillator and comparing them with the lows in price, you can see 3 different situations:
So, 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.
Looking at the highs of the oscillator and comparing them with highs in price, you can see 3 other situations:
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.
A divergence with a higher bottom in the RSI indicator and a lower bottom on the price chart is an indication 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.
A hidden or inverse divergence with a lower bottom in the RSI and a higher bottom in price is most common found in an uptrend. There is not yet a divergence between the previous tops. The down correction is apparently just an intermediate correction for the previous uptrend. This hidden divergent move points in the direction of a continuation of the previous uptrend. You can use the divergent turning point as a price support level.
A hidden or inverse divergence with a higher top in the RSI and a lower top in price is most common found in a downtrend. There is not yet a divergence between the previous bottoms. The up correction is apparently just an intermediate correction for the previous downtrend. This hidden divergent move points in the direction of a continuation of the previous downtrend. You can use the divergent turning point as a price resistance level.
The 30-70 fixed reference level used in the standard RSI is a disadvantage if you are using time periods other than the standard 14 bars. Using a 30-day RSI in this daily chart shows clearly that the 30 and 70 levels are not reached anymore.
We can solve this by using a variable reference level. In this chart you can see a simple way of achieving this by using a standard-deviation value referenced to the median RSI 50 level in a predefined look-back period. We set the upper standard deviation to a value of 50 plus 1.5 times the standard deviation over a 100-day look-back period. That way with larger RSI time periods the reference level will move closer to the 50 level in the order 40 to 60, whereas for smaller period’s reference levels move farther away to the 20 and 80 levels. It is now easier to recognize overbought or oversold conditions with ANY RSI time period.
This is the RSI MetaStock custom formula with the variable standard deviation lines at 1.5 times the standard deviation over a 100-days period. This formula is available on my website as indicated.
Small M- and W-shaped patterns are short time patterns visible in the overbought and oversold areas, or the 50-reference of the RSI indicator. In this chart you can see small M-shaped patterns at the top and small W-shaped patterns at the bottom giving reliable short-term price reversal signals. Preferably, they’ll incline in the direction of the reversal. The second leg of the M-shaped pattern does not move above the first leg. The second leg of the W-shaped pattern does not move below the first leg. M and W patterns are unrelated to convergences or divergences between the price and RSI indicator. They are more useful when there is a convergent move because they are at that moment in time, the only visible indicators of, at least, a short-term reversal.
The RSI indicator is most useful to detect price trend reversals based on normal or hidden divergences and using the M and W short term patterns in case of convergent price moves. Overbought and oversold areas can best be detected with an active standard deviation band. This is certainly one of the indicators that will help you to make better trading decisions. In the next video we will talk about heikin ashi price bars and how we can use the heikin ashi average closing price to smooth indicators. Tell your friends about these videos and while visiting my website have a look at my new book “Capturing Profit with Technical Analysis”. Have a nice day.
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