Rsi Relative Strength Index: Using It To Spot Contrary Trades

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The best trends come when most people least expect them bull moves collapse and bear trends develop and traders are left scratching their heads wondering how it could happen.

These are trades that offer simply the best risk reward and you can spot them using contrary indicators such as the RSI lets look at it.

The Relative Strength Index was developed by trader Wells Wilder (check out his excellent book New Concepts in Technical Trading) and is a Momentum indicator and probably the most widely used contra-trend-oscillator in the world.

The RSI does not show just the markets strength but the strength compared to the markets former price history.

The technical bit

The RSI is calculated in the following way:

Within a set period, the individual differences between the upward closing prices (Close today < Close previous day) and downward closing prices (Close today > Close previous day) are added.

Then the number is divided by the number of observations in the period studied minus one.

The result is the day?s mean value of the upward and downward strength of the market studied.

Then the relative strength is calculated by dividing the average upward strength by the average downward strength.

The RSI is found by subtracting from 100 the quotient of 100 divided by one plus relative strength.

This is then displayed visually and you can see it on free chart services such as futuresource.com
Properties

If the chart displays daily data, then period obviously denotes days; in weekly charts, the period will be weeks etc

The shorter the Period of time used for the calculation, the more volatile the RSI will be.

The RSI has a default of 14, which is the value devised by Wilder when originally calculating RSI.

Other values have become popular such as 9, 11, and 25 days.

Overbought ? Oversold

The main purpose of the RSI is to measure the market?s strength and weakness
An RSI, above 70, indicates an overbought bull market.

On the other hand an RSI, below 30, indicates an oversold market.

While the RSI can be used as an overbought and oversold indicator it does have other uses.

Divergences between Price and RSI

For example, the market makes new highs on the chart but the RSI fails to exceed its previous highs indicating that the trend is about to exhaust itself.

Don?t use it on its own

When using the RSI in this way like many contrary indicators it does NOT indicate you should buy or sell.

A warning of opportunity

Instead, it is telling you the conditions are ripe for a move and you need to add other indicators to time your move.
We like the stochastic indicator but there are many options and traders need to experiment and find what works for them.

In conclusion

RSI is one of the best contrary indicators and we use it as one of 3 the other two being: % Bullish and The Commitment of Traders Report.

Try it to set up trades and then time your entry levels and you could soon be making some great contrary trades with big profit potential and low risk.

By: Sacha Tarkovsky

FREE ESSENTIAL TRADER PDF’S AND MUCH MORE On all aspects of becoming a profitable trader including features, downloads and some great FREE Trading PDF’s visit our website at www.net-planet.org/index.html

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