The RSI indicator is popular with many traders. RSI stands for ‘Relative Strength Index’ and was developed by J. Welles Wilder in 1978. Understanding relative strength and weakness involves determining overbought or oversold conditions based on price changes over a specific period.
We have previously published a series of articles on Bollinger Bands® (BB) which is a powerful technical analysis tool. In particular, the Bollinger Bands® %B (or Percent Bandwidth) is an indicator that helps confirm trends and distinguish overbought and oversold conditions. If you’re new to Bollinger Bands, please read our previous article on Bollinger Bands - Introduction and key points. Suppose you are using this tool in your prop trading strategies. In that case, you may want to dive into our previous article on the four main patterns of Bollinger Bands® Squeeze, expansion, max bandwidth and bandwalk to help determine changes in or the continuation of the price trends of an asset.
In this article, we will discuss the Relative Strength Index (RSI), another tool for identifying market overheating.
1. Identifying market overheating
Among the various momentum oscillators, the RSI indicator, developed by J. Welles Wilder in 1978, is popular with many traders. Understanding relative strength and weakness can be challenging. Simply put, it involves determining overbought or oversold conditions based on price changes over a certain period.
J. Welles Wilder calculates the RSI using the following formula, which is also used in MetaTrader 5 (MT5):
RSI for the first day = U / (U + D) × 100
RSI for the second day onwards = U2 / (U2 + D2) × 100
U = Average upward price change over n days
D = Average downward price change over n days
U2 = [(U × n-1) + previous day's upward price change] / n
D2 = [(D × n-1) + previous day's downward price change] / n
Some charting software also employs the concept of continuing calculations from the second day onwards in the same manner as the first day. However, there is not much difference between the two methods.
Furthermore, Wilder recommends using a parameter of 14 days. This period effectively captures the range of oscillations and smooth market trends within a specific range of fluctuations.
2. Overbought and oversold zones
The RSI fluctuates between 0% and 100%, reflecting the market's overheating. Wilder’s basic analysis method considers below 30% oversold and above 70% overbought.
As these ranges indicate overbought and oversold market conditions, it could be an opportunity to start countertrend trading. This involves trading against the previous market trend: selling when the uptrend exceeds 70%; and buying when the downtrend falls below 30%.
Basic method for RSI analysis:
- Below 30%: Considered oversold, therefore a buy opportunity
- Above 70%: Considered overbought, therefore a sell opportunity
Figure 1. Pay attention to the RSI zones below 30% and above 70%.
3. Using Zone Exit as a basis for trading
When the price enters the zone below 30% or above 70%, it is called Zone Entry, and when it exits that zone, it is called Zone Exit.
Zone Exit indicates the market is leaving the overbought or oversold area, which may be a signal to exit a trade; and Zone Entry indicates the market is entering the overbought or oversold area, which may be a signal to enter a trade.
When using the RSI to determine overbought/oversold conditions, it is essential to base the analysis on the latter. When trading, base your assessment on Zone Exit.
In other words, the focus should be on the time of exiting the zone (shown in red in Figure 2) rather than the time spent within the zone (shown in blue in Figure 2).
Figure 2. Zone Exit
Summary
The RSI, or Relative Strength Index, assesses the market’s relative strength or weakness based on price movements over a specific period. J. Welles Wilder developed this indicator in 1978.
The RSI fluctuates between 0% and 100%, indicating the market's overheating. The basic analysis method considers below 30% oversold and above 70% overbought.
These ranges indicate overbought and oversold market conditions, suggesting counter-trading potential. Counter trading involves trading against the prevailing market trend, selling when the uptrend exceeds 70%, and buying when the downtrend falls below 30%.
Apart from the RSI, there are many other technical analysis tools you can learn and use, such as correlation tool, sentiment tool, and currency strength tool. Incorporating these tools as part of your trading plan will enable you to analyse the markets more precisely and enhance your prop trading performance.
Besides tools and research, the journey to becoming a successful prop trader gets easier when you engage with fellow traders like yourself. Interacting with other traders can sharpen your skills and motivate you in your prop trading journey. A good community of traders may just make a difference to you passing the prop trading evaluations and becoming a funded trader.
If you’re seeking like-minded traders, why not join our OANDA Prop Trader Community? When you join the community, you'll get to participate in discussions, obtain expert insights, and earn coins that you can use to redeem rewards.
Start trading smarter by joining our community now.
