<s> ISBN 0-934380-88-090000
9
80934380881
RSI:
The Complete Guide
Traders Press, Inc.®PO Box 6206
Greenville, SC 29606
John Hayden
Copyright© May 2004 by John Hayden
All rights reserved. Printed in the United States of America. No part ofthis publication may be reproduced, stored in a retrieval system, or trans­mitted, in any form or by any means, electronic, mechanical, photocopy­ing, recording, or otherwise, without the prior written permission of thepublisher.ISBN: 0-934380-88-0Published by Traders Press, Inc.®
This publication is designed to provide accurate and authoritative infor­mation with regard to the subject matter covered. It is sold with the un­derstanding that the publisher is not engaged in rendering legal, account­ing, or other professional advice. If legal advice or other expert assistance .is required, the services of a competent professional person should besought.
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Traders Press, Inc.®POBox 6206Greenville, S C 29606
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DEDICATION
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ACKNOWLEDGEMENTSIn the preparation and the writing of this book there were many peoplewho contributed, inspired, and encouraged my efforts in placing these
thoughts onto paper. Additionally there are many people that have guidedme in my efforts in becoming a better trader. I would particularly like toexpress my gratitude to my wife Valeriya Hayden for patience and en­couragement, Christopher Castroviejo whose mentoring was crucial inmy understanding of time analysis and the "big picture", and AndrewCardwell who taught in his seminars of the early 1990's some of the con­cepts mentioned in this book.
SPECIAL THANKSCreating this manuscript was made possible with the help of three indi­viduals. I would like to take this opportunity to thank my wife, ValeriyaHayden, who has supported me in countless ways. I would also like to
thank Joe Schedlbauer, who was invaluable in critiquing the ideas that thismanuscript encompasses. And finally, I would like to thank Edward Dob­son. His unfailing encouragement helped me complete the writing of thiscomprehensive book about the RSI. Without this encouragement, thismanuscript would never have been born. Thank you.. . '.-
.
.. .
A book only comes "alive" when the reader becomes involved with thesubject matter. I would like to take this opportunity to say "Thank you" tothe readers of this book for taking their valuable time to learn more abouttruly understanding price behavior.
Table of ContentsTable of ContentsSection I - Preparation and Understanding - The Key to Success!
1.
2.3.
4.5.
6.7.
OverviewRSI MathPrice BehaviorThe Real NatUre of The Market placePrice Behavior & The RSIBasic Retracement TheorySummary Section I
1
5
13
19
21
27
43
Section II - Using the RSI to Trade!1.
Conventional RSI Use4555Professional RSI Use593. Trend Determination Using RSI4. The Truth About Divergence65735. Momentum Discrepancy Reversal Points6. Trend Direction Using Momentum DiscrepancyReversal Points817. The Relationship Between Price & RSI Retracements83858. Valid Support & Resistance Price Levels9. Help! A Longer TimeFrame Just Jumped in My Puddle! 8910. Conclusion912.
The Complete RSI Book
Chartine Table of Contents
Chart 1 - Basic Retracement TheoryChart 2 - Basic Retracement Theory - 3 -minute ChartChart 3 - Failure SwingChart 4 - RSI vs. RMIChart 5 - RSI vs. RSI Morris ModifiedChart 6 - RSI 14 Period vs. RSI 3 PeriodChart 7 - RSI 14 Period vs. RSI StdDevChart 8 - RSI Uptrend 15-minute ChartChart 9 - Uptrend I-minute ChartChart 10 - Uptrend 5-minute ChartChart 11 - Downtrend 5-minute ChartChart 12 - Uptrend 5-minute Chart wi 40 NegatedChart 13 - The Rise of Intel - Where is theBullish Divergence?Chart 14 - Divergence Becomes Support or ResistanceChart 15 - Long Term Multiple Bull DivergenceChart 16 - Hidden Bullish DivergenceChart 17 - Multiple Long Term Divergence with StochasticChart 18 - Momentum Discrepancy Reversal UpChart 19 - Momentum Discrepancy Reversal DownChart 2 0 - Trading Chart With Prices (actual trading chart)
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6568697071747886
"In trading, as in life, what often appears obvious is not importantand what is not obvious is important. " - John Hayden
SECTION IPREPARATION AND UNDERSTANDING - THE KEy TO SUCCESS!CHAPTER !
OVERVIEWIn the "old" pre-personal computer days, bar charts and indicator values had tobe calculated and plotted by hand on honest-to-goodness paper charts. It was duringthis 'early' time that the Relative Strength Index or RSI first made its appearance.In June 1 978, Welles Wilder introduced the Relative Strength Index to the trad­ing community in an article for Commodities Magazine.
Concepts in Technical Trading Systems.
"
In his classic book,
"New
Mr. Wilder provided step-by-step instruc­
tions on calculating and interpreting the Relative Strength Index. As time has passed,other indicators with similar sounding names have been developed. The majority oftraders refer to this index as the "RSI" instead of the "Relative Strength Index." This
helps to avoid confusion with other indicators with similar names. For example, Investor sBusiness Daily publishes its "Relative Strength Rankings" and John Murphy promotes
his "Relative Strength Charts." Neither of these 'relative strength tools' is related toWelles Wilder's Relative Strength Index or RSI, as we shall call it.The Relative Strength Index (RSI) is one of the most popular momentum oscil­lators used by traders. It is so popular that every charting software package and profes­sional trading system anywhere in the world has it as one of its primary indicators. Notonly is this indicator included in every charting package, but it is not out of the realm ofpossibility that every system has identical original default settings.
1
John HaydenThere are many reasons that the Relative Strength Index quickly became sopopular with traders. When hand plotted in conjunction with a daily bar chart, it providedinterpretative information on market tops and bottoms, chart formations, market rever­sals, areas of support/resistance, and price/indicator divergence. All of this informationwas rolled into one easy to calculate formula, so what was not to like? At this time,enter the personal computer bringing with it the ability to manipulate numbers in the blinkof an eye. The personal computer has made the process of decision-making so easywith instant real-time charts and indicator overlays that most traders simply do not knowwhere to begin.It is so simple to jump into trading using the preset system default values thatnovice traders often begin trading without testing different parameters or educatingthemselves on the proper interpretation of an indicator because of the desire to makemoney quickly! As a result, the RSI is also one of the most widely misused technicalindicators!Once understood and correctly applied, the Relative Strength Index has theability to indicate whether prices are trending, when a market is overbought or oversold,and the best price to enter or exit a trade. It can also indicate what trading timeframe ismost active and provides information in determining key price levels of support andresistance. However, in order to fully understand the Relative Strength Index, we mustfirst understand how price behavior affects it.The calculated value for Wilder's RSI oscillates between 0 and 1 00. This valuerepresents a ratio of the average recent time period price 'gains' to the average recenttime period price 'losses' calculated over a number of time periods. In other words, itcompares the internal strength of a security or market.
A trip into any professional
trading office in the world will reveal at least one or two charts with this indicator beingplotted on at least one monitor. It is the opinion of many professional traders that thisone indicator, of all the widely known indicators - is the most versatile and powerfulindicator that is available.This book will attempt to convey the information that a trader would want orneed to know about the Relative Strength Index. There is a considerable body of infor­mation that has been gathered concerning the RSI since 1 978 when Mr. Wilder pro­moted this indicator in his groundbreaking book. While it is impossible to discuss all ofthe knowledge that is available on the subject of the RSI, when you have finished study­ing this short book you will know how to use it to determine:
2
RSI: The Complete Guide1.2.3.4.
The current trend.The best entry/exit prices for a trade.Price levels where contra-trend market retracement will likely end.Basic Price Retracement Theory and Momentum Discrepancy ReversalPoints.
5.
What is meant by the term "timeframe".
6.7.
When a different "timeframe" is negating or overpowering the present
8.
How to determine upside or downside price objectives that have high prob­
How to determine the dominant market "timeframe".timeframe.ability of being reached.Every profitable trader has learned that he or she must possess their own "edge"
that enables them to regularly extract money from the market place. For a trader to
have an "edge," he or she must have an accurate perception of the market that is also
unique. The applied definition of a trader with an "edge" is a trader with an accurate
perception of the market place that differs from other trader's perceptions. The con­verse of this argument is that if all of the other traders have or get the same perceptionof the market, the trading "edge" will quickly disappear. Including this thought makes itnatural to expect that any advantages found in using the RSI would have long sincedisappeared since Mr. Wilder published his original information about the indicator in
1 978.While this expectation might be true in a perfect trading world, it is not the casein the chaotic world that we live in.
The advanced and largely unknown concepts
mentioned in this book are as effective today in 2004, as they were in 1 978 when "New
Concepts" first hit the bookstands. In fact, these advanced concepts with somemodifications can also be beneficially applied to other momentum-based indica­tors.If asked, many seasoned traders will tell a novice trader that it is important tofocus on truly mastering one indicator. It is essential to know when and why an indicatoris about to behave in a certain way. Once an indicator is truly mastered, the trader isable to apply his own unique perceptions and rules to it. Many inexperienced traderswant to believe that they have mastered an indicator simply because they know itsparticular trading "rules" governing entries, exits and stops. The reality is that they"know" no more than any other trading novice. Consequently, they have no "edge"versus other traders when using a particular indicator, which is one of the primary rea­sons that 99% of all new traders lose their money.
3
John HaydenIt is my hope that you as the reader will take some time to realize how the RSIfunctions and see the dramatic benefits that can be obtained by using it in a more profi­cient manner. Once mastered, the Relative Strength Index provides key informationtelling when the market is trending and when it is overbought or oversold. The RSI canalso provide strategic price levels to enter or exit market positions and give insight intowhen it is best to stand aside. In my mind, there is no other widely known indicator thatis as effective and/or profitable!This book is divided into two sections. In Section I, the focus is on developingthe basic knowledge of the Relative Strength Index that is necessary to use with theadvanced concepts. Without a thorough understanding of the basic concepts that areinvolved, the trader will have neither the courage nor confidence to consistently takeaction when the price action conveys a valuable clue.Section II focuses on integrating the basic knowledge of price behavior,retracement theory and various timeframes with RSI theory. Also in Section II, we willlearn how to enter and exit trades more profitably.
4
CHAPTER 2
RSlMATHIt is an accepted fact that the simple geometric formula resolutely declaring, "pi(3. 1 4 1 6) times 'd,' the diameter of a circle" yields its circumference. This simple for­mula has dramatically changed the world that we live in. The formula for calculating theRelative Strength Index is also relatively simple. In some ways, this formula for calcu­lating the Relative Strength Index has just as profoundly changed the trading world in thefew short years since its introduction.In this section, we will discuss the math and perhaps more importantly, the logicofthe math that is used in computing the Relative Strength Index. The single ending RSIvalue is the ratio calculation between the average increase in price versus the averagedecrease in price over a pre-defined period of time. It is a front-weighted momentumindicator, which gives it the ability to respond quickly to price changes. Because of itsmathematical construction, it is also less affected by the sharp price swings that occurfrom time to time in markets.There are two equations that are involved in solving the formula. The firstcomponent equation obtains the initial Relative Strength (RS) value, which is the ratio ofthe average UP closes to the average DOWN closes over 'N' periods represented inthe following formula:RS
=
Average of 'N' day's closes UP/Average of 'N' day's closes DOWN
The actual RSI value is calculated by indexing the indicator to 1 00 through theuse ofthe following formula:RSI
=
1 00 - ( 1 00 / 1 + RS)
5
John Hayden
This second component equation yields the final RSI value. To calculate thefirst value of the RSI, the previous 'N' days' price data is required. From then on, allthat is needed is the data from the previous day.In calculating for the value for RSI on succeeding days, the 'sum of gain' inprice in 'N' time and the 'sum ofloss' in price in 'N' time is multiplied by one less thanthe fixed period of time 'N'. The gain or loss for the next subsequent bar is added andthe resulting number is divided by the fixed period of time 'N' . We can see this in thefollowing formula.RSI 1 00 - ( 1 00/1 +[((Sum of gain in price in 'N- I ' past intervals· 'NI ')+Gain this bar) / 'N' / ((Sum of loss in price in 'N- l ' past intervals· 'N-I )+ Loss this bar) / 'N']=
'
Where:RSlI Initial RSI value'N' is the length of time intervals that is referenced in the past. For example,1 4 of the prior bars.=
In other words, 'N' is an interval of time. If the price action that is plotted iswhere each day is represented by I bar, and ifN 5, the RSI value is looking back at thelast 5 days.=
Table # 1 (on the following page) shows the values in calculating the RSIwhere N 14 in a hypothetical market.=
6
Table # 1
-
RSI Calculation
AvgGain AvgLoss RS
RSI
7
Chg
Gain
Loss
12345678910111213
Close1161.321161.281161.391160.751160.711160.791160.161159.671159.741159.181158.991159.241158.931158.94
0.04000.1100-0.6400-0.04000.08000.6300-0.49000.0700-0.5600-0.19000.2500-0.31000.0100
00.1100000.0800000.0700000.250000.0100
0.040000.64000.040000.63000.490000.56000.190000.31000
14
1 1 58.77
-0.1 700
0
0.1700
0.0 3 7 1
0.2 1 3 6
0.1739
1 4 .8 1 5
15161718192021222324
1158.781157.71157.091156.881156.561156.571156.611156.751156.711157.06
0.01001.08000.61000.21000.32000.01000.04000.14000.04000.3500
0.010000000.01000.04000.140000.3500
01.08000.61000.21000.32000000.04000
0.03520.03270.03040.02820.02620.02500.02610.03420.03180.0545
0.19830.26130.28620.28080.28360.26330.24450.22700.21370.1984
0.17750.12510.10610.10040.09230.09500.10670.15070.14870.2747
15.07511.1209.5899.1238.4508.6779.64113.10012.94721.552
�
.
.
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John Hayden
It should be noted that it takes many more days ofdata to smooth the RSI value.This table is an example only. See point Number 2 in the list below.If you would like to see the Excel spreadsheet formulas on constructing thisspreadsheet, please see Appendix A.There are a few main points to remember about the RSI calculation:1. The second formula changes the structure of the RSI from a simple movingaverage of the gains and/or losses to an exponential moving average.2. The second formula requires at least 10 times 'N' time intervals to stabilize theRSI value and it is better to have to have 20 times 'N'. In other words, ifN14 days, then we need 1 40 days of prior data for the RSI value to be of use.This is assuming daily data is used.3 . The second formula, because it i s an exponential moving average, incorporatesall prior price behavior into the RSI value. This adds more weight to thepreceding bar price behavior.4. As 'N' or time periods used becomes larger, the RSI value oscillates less vigor­ously. As 'N' becomes smaller, the oscillations of the indicator become morepronounced.
=
On the following page is an example of how changing 'N' changes the RSIamplitude:
8
RSI: The Complete GuideTable # 2
-
123456789101112131415161718192021222324
RSI Look-back 3 periods versus 14 periods.
Close1 1 6 1 .321 1 6 1 .281 1 6 1 .3 91 1 60.751 1 60.7 11 1 60.791 1 60. 1 61 1 59.671 1 59.741 1 59. 1 81 1 58.991 1 59.241 1 58.931 1 5 8.941 1 58.771 1 58.781 1 57.7 01 1 57.091 1 56.881 1 56.561 1 56.571 1 56.6 11 1 56.751 1 56.7 11 1 57.06
RSI N = 3
RSI N = 1 4
15.4914.2930.539.435.221 3 .496.595.2332.682 1 .2422.551 5.831 7.983 .492.071 .7 11 .232.529.6434.6730.9971.16
14.8 1 51 5 .0751 1 . 1209.5899. 1 238.4508.6779.6411 3 . 1 001 2.9472 1 .552
So, what can we tell about the RSI at this point?1 . The RSI value oscillates in a range between 0 and 1 00.2. Small changes in price will cause larger changes in the RSI value.3 . ChaJ?ging the look back 'N' time interval will cause the following:a. The RSI amplitude swings decreases, when 'N' is increased.b. The RSI amplitude swings increases, when 'N' is decreased.4. The RSI includes prior price action within its value. This requires a largenumber of prior time intervals for the oscillator to stabilize.9
John Hayden
Let's explore some of the internal characteristics of the Relative Strength In­dex. For this demonstration, we will use the first formula of the calculation also knownas the ' Morris modified RSI,' which demonstrates certain internal characteristics of theindicator. Table #3 is a spreadsheet that shows the relationships between the Gainaverage and the Loss average as a ratio. The most important ratios in the table are inbold print for emphasis.Table # 3
-
Ratio Table
Up Avg
Dn Avg
RSI
Up Avg
Dn Avg
12
11
50.00
1
66.67
1
12
3
1
1
3
4
11
75.0080.0085.71
111
56
56
I
83.33
78
11
91011
1I1
1213
11
92.3192.86
1
141516
111
93.33
11
1719
111
20
1
18
87.50
1
88.89
1
90.00
11
90.9191.67
11
93.7594.12
1
94.4494.74
11
95.0095.24
11
4
7891011121314151617181920
RSI50.0033.3325.0020.0016.6714.2912.5011.1110.009.098.337.697.146.676.255.885.565.265.004.76
The RSI value calculates to 50 if the value for the Up Average is equal to thevalue for the Down Average (1:1 ratio). As the Up Average increases when comparedto the Down Average, the RSI value steadily increases from 50 to 100. Careful exami­nation of Table #3 reveals that the RSI value behaves logarithmically!As the Up Average increases to infmity and the Down Average remains steadyor decreases to a level that approaches zero, the rate of increase shown by the RSIslows to a crawl. Let's take a closer look at these ratios. When the ratio is 2:1, the upaverage is twice as much as the down average. In this case, the Relative StrengthIndex value is 66.67.10
RSI: The Complete GuideIt is interesting to note that when the Gain versus Loss ratio changes from 1 : 1 to2: 1 , the change in the RSI value is 1 6.67 points. When the ratio moves from 2: 1 to 3: 1 ,the RSI value only increases another 8.33 points. For the Relative Strength Index to hitthe '80' level, a ratio of 4: 1 is needed. This is an Up Average that is four times largerthan the Down Average and is a condition that does not occur very often.Looking back at Table #3 where the ratios are reversed, when the Down Aver­age moves from 1 : 1 to twice the Up Average ( 1 :2), the RSI value decreases to the samedegree as a 2: 1 increase. This pattern continues throughout Table 3 as the ratio de­creases.When the ratio is 20: 1 and the Up Average is 20 times the Down Average, theRelative Strength Index value at this time is only 95.24. This is a market condition thatalmost never occurs when the look back period is 1 4 bars!By carefully studying the ratio relationships in Table # 3, we can glean thefollowing information about the Relative Strength Index:1 . When the RSI is above 50, the indicator is telling us that the average gainexceeds the average loss.2. When the RSI is below 50, the indicator is telling us that the average lossexceeds the average gain.3. The RSI behaves like a logarithmic curve.4. Anytime the ratio exceeds 1 0: 1 , the market has been experiencing a verystrong move up.5. Anytime the ratio exceeds 1 : 1 0, the market has been experiencing a verystrong down move.6. The largest increase or decrease in the RSI value occurs when the ratiochanges from 1 : 1 to the next whole number (2: 1 or 1 :2).7. The RSI value experiences its largest changes in value as it oscillates be­tween the index values of 40 and 60. In other words the RSI is most sensitiveto price change when the RSI is oscillating between 40 and 60.As we shall see later, these observations are crucial to fully understanding theinterplay between price activity and the RSI. It is not enough to understand that youshould take a certain action whenever the RSI does this and/or that. It is important thatyou also understand the "why!"
11
12
CHAPTER 3
PRICE BEHAVIORA thorough discussion of price behavior deserves its own book. However, inour effort to understand the Relative Strength Index, we will limit our discussion to theprice behavior characteristics that relate to how the RSI behaves.In this section, we will discuss price behavior. Unfortunately, when the majori:tYof traders consider price behavior, they immediately think of price patterns. Pricebehavior causes the creation of certain bar (price) patterns that are visible on a pricechart. Just as the moon creates tidal forces that create high and low tides, price behav­ior creates price patterns. We could plot the levels of high and/or low tide on a chart anduse the information contained in the chart to surf or launch a boat. However, simplyseeing the frequency of high and low tide levels will not explain what has caused thedifferent tide levels that are shown on our chart. Similarly, a price chart displays variouspatterns that could be used to generate profits. But without understanding the why ofhow these patterns were created, we will not be able to trade as profitably as wepossibly could. This chapter focuses on the 'why. ' What are the forces that cause bulland bear markets? To profitably use the Relative Stren�h index, we must understandcertain minimum concepts regarding price behavior.The price for any commodity futures contract or security is based upon thebeliefs of the strongest group in the trading arena. Many people think that they under­stand price action - most do not. If the majority of traders really understood price action,the constant up and down volatility that we see in the market place would largely disap­pear. In its place, we would see relatively steady prices with sudden huge uni-direc­tional price movements with no contra-trend or retracement moves.
13
John HaydenCORN TRADERS
The best way to explain price behavior is using an example with three hypo­thetical corn traders (Adam, Bob and Charlie) plus all of the on and off-floor traders.The price for a bushel of corn or any other commodity or security is the price that twotraders agree to at an instant in time - free of duress. After all, if one trader is holdinga gun to the other trader's head, forcing him to sell the bushel of com cheaply, it isn't avalid trade and does not represent a valid price. If the trade was "forced", the price ofthat "trade" is not a valid representation of What a bushel of com is worth in the realworld and is worthless information to other traders.Traders who agree to a mutually established price provide other traders with acertain amount of information. This information may or may not be valuable to some orall of the other traders. If there is only one trade, the only thing the other traders candetermine is that the price these two traders think is fair is "x". Should the two tradersagree a few minutes later to make another trade, then this new information will tell all ofthe other traders that the price has changed up, down, or has remained the same. Fromthe trades, the other com traders cannot tell anything more than that the price of comhas changed. It is also not possible for them to know if the trade price was made free offorce. If the trade price is made under coercion/force/threat, then that trade price isinvalid. For example, ifwe assume that both corn traders are well informed tradersand neither one is under any pressure to buy or sell corn other than a desire toprofit, then the price the corn is traded at represents a valid price. Should thetrade be made because of force or coercion, the price of the trade is invalid.Why is this price information important? Because at its most simple level, allthat is needed to make a market place are two traders who agree upon a price ofexchange. Many people think that the market is constantly determining the "best" ormost