Trading With Relative Strength Index
Relative Strength Index or RSI is an oscillator that measures the strength of up or down moves in price relative to the stock’s previous price movements. The typical readings for this indicator are 70-30. A reading of 70% means that the stock is overbought and likely to drop soon. The RSI crossing below the 70% line is sometimes taken as a sell signal. Conversely, a reading below 30% shows the stock to be oversold and perhaps ready to rise. A buy signal is said to be generated when the RSI crosses above 30.
Traders should also look for Positive & Negative divergence on RSI.Positive divergence is prices making lower lows and RSI making higher lows. Negative divergence is prices making higher highs and RSI making lower highs. Positive divergence suggests downtrend or decline may take a pause or there could be a trend reversal. Negative divergence suggests the up move has matured and prices can see a correction to the downside.
Fig 1. Nifty posted a lower lows on daily chart at 4788 on 18 May 2012 and 4770 on 4 June 2012.RSI on the daily chart during the corresponding time posted a higher lows suggesting loss of momentum on the downside and a trend reversal. Nifty from the low of 4770 after exhibiting positive divergence in the oversold zone has rallied to 5348 a decent up move. Currently the RSI is also exhibiting overbought reading suggesting its time to book profit.
When trading with RSI , traders should look for. Oversold reading with positive divergence to enter long positions. Overbought reading with negative divergence to enter short positions.
The author is Trading Mentor, Online Trading Academy