By: Steve Smith
One of the keys to profitable options trading is identifying good entry points in terms of both time and price. This is where technical analysis becomes a can be important tool. Within the spectrum of various technical indicators, the Relative Strength Index (RSI) is among the most popular and reliable, but is also widely misunderstood.
Calabri Trader explains the RSI Indicator in this article.
The relative strength index (RSI) represents the size of recent gains and losses, during a specified time period, and measures the speed of these price movements. It is therefore primarily used to identify potential overbought and oversold situations for a particular currency pair. Wilder recommends using a 14-day period as the standard setting for the RSI.
The RSI has a higher value when the average gains for the specified period are larger than the average losses. In the opposite situation, when average losses are larger than average gains during the period, the RSI value moves down. The following chart shows the RSI indicator on the EUR/USD currency pair (blue), notice how the value of the RSI is normalized between 0 and 100.
The RSI can also be used on time frames different than the daily, but traders need to pay attention that a shorter setting for the period creates a more volatile RSI, while a longer period creates an RSI less sensitive to price changes.
Related: Profit and Probability, Part 3
The indicator is calculated the following way:
RSI = 100 – [100/(1+RS)]
RS = Smoothed Average Gain / Smoothed Average Loss
Average Gain = Sum of gains for the specified period
Average Loss = Sum of losses over the specified period
To create a Smoothed Average Gain, the following calculation is performed:
Smoothed Average Gain = [(previous Average Gain) x 13 + current Gain] Smoothed Average Loss = [(previous Average Loss) x 13 + current Loss]
Wilder normalized the RSI with this formula to have a range value from 0 to 100. Simply put, if over the specified period each session was a gain, then the RSI would have a value of 100. If each session was a loss, the RSI would have a value of 0.
The RSI is a multi-purpose indicator, which only added to its popularity. The most popular uses of RSI include:
- Identifying overbought/oversold areas
- Trading the RSI divergence
1. Overbought and oversold areas
A common use of the RSI is for identifying when a currency pair (or another financial instrument) is overbought or oversold. The usual values of the RSI used for this are 30, which indicates an oversold area, and 70, which indicates an overbought area.
If the price moved strongly up in the recent periods, the RSI will react with a higher value. The presumption behind this is that a quick jump in price is usually not sustainable and will eventually result in a correction move down. Therefore, if the value of the RSI is 70 or more, it is considered an overbought area and traders should expect a drop in the price.
Similarly, a quick drop in the price will move the value of the RSI lower into the area of oversold conditions. In this case, it the RSI shows 30 or lower, traders should be prepared for a possible correction move upside.
As the RSI is a momentum indicator, it can also often produce fake signals. Therefore, an additional confirmation regarding the direction change should be utilized. One of the popular ways of opening positions in case of overbought and oversold areas, is to let the RSI go above 70, and then wait for the value to break below 70 again to open a short position. In case of oversold areas, wait for the indicator to go below 30 and then to break above 30 again, for a buy signal. This is required because the RSI can remain in overbought and oversold areas for a long time if the currency pair is forming a new up or downtrend.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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