The Relative Strength Index
The Relative Strength Index (RSI) is an oscillator that is used to identify turning points by measuring the pattern of highs and lows to measure the speed and change of price. When markets are trending an RSI can give premature signals resulting in winners being cut early or trades being taken too soon. In the right context, an RSI signal can be very effective at providing leading or coincident trade signals.
1. Divergence- The strongest signal an RSI produces is when prices makes a new high/low but the RSI makes a lower-high/higher-low. A strong sign is if the high/low breaches the oversold/overbought area and the lower-high/higher-low does not breach. In figure 1 a new low is made both in price and the RSI at point A. However, there is bullish divergence at point B where price makes a new low but the RSI has a higher low. This indicates that the trend is weakening and we have formed a bottom failure swing and look to enter long.
Figure 1 Daily EURJPY RSI(14) divergence
2. Trendlines and Support/Resistance- A signal for a change in trend is when the RSI forms support, resistance or trendlines which the RSI breaks through before price. When the pattern is broken look to enter a breakout trade long/short. The RSI support/resistance levels also provide opportunities to enter with the trend if the patterns are respected. In figure 2 the trend is lower until bullish divergence forms on the last exhaustive move lower. Price starts to form a wedge as the RSI develops an upward sloping trend channel. The divergence between price pattern and RSI pattern signals a change in character that confirms a bias to enter long on the break of the wedge. The break of the RSI resistance from the downtrend signals the end of the trend and confirms a bottom failure swing has been fo
Figure 2 Daily EURJPY RSI(14)