Learn With ETMarkets: You, me and trading: Discussion of trading strategies using RSI indicator

Me: I had a wonderful trading session today. Trading is easy if you learn some simple techniques. People tend to complicate things unnecessarily.

You: That’s right. It appears that you have developed a strategy that suits your style & temperament.

Me: I developed a strategy based on RSI and Moving Average indicators. It works perfectly, there is no need for anything else.

You: Great. Have you practiced it enough?

Me: I learned about it on social media and observed it in many charts. In fact, I even took a trade today based on it. I guess the strategy does not lose.

You: Observing charts is fine. You cannot often identify tops or bottoms being completed on a live basis. It is mostly identified in hindsight. However, it is possible to backtest strategy. We will discuss the issues associated with that later. What’s important is have you understood the technique?Me: Of course, I did. I even traded based on it.

You: Taking trade is the easiest part of the process. What is more important is to ask yourself if you have a good understanding of the process or strategy?

Me: Oh, you mean the formula. I know it, but there is no point getting into it. I like to focus on the practical aspects.

You: That is totally fine. So, are you suggesting trading is practical, understanding is theoretical? Do you know what the RSI indicator is all about? And what pattern are you trading?

Me: Yes, I have seen the formula. It basically illustrates strength and momentum. I trade based on the RSI indicator, not the price.

You: It’s not the formula that I’m referring to. In spite of the fact that most people use this indicator, they do not really understand it. Ok, I’ll explain the pattern you are trading. Let me explain the indicator.

RSI is a momentum indicator invented by J. Welles. Wilder. It calculates a ratio of bullish prices and is always calculated using the closing price of a session.

When the current closing price is above the previous closing price, it is bullish. Else, it is bearish. This helps us identify and categorise the trend of any session as bullish or bearish.

That’s what RSI does first for all sessions in the period you are using.

Next question is: If the trend is bullish then how much is it bullish? If bearish, how much is it bearish?

This can be answered by comparing the price of the current session with the price of the previous session.

The next step is to calculate the average gain and average loss for the given period. I will illustrate this with an example of 5 trading sessions.

Have a look at the below chart. Returns are 20 points in 5 sessions.

There were gains of 10, 5, and 15 points in five sessions. We are looking at a 5-day pattern, so we divide it by 5. Hence, the average gains are 6 points. Losses add up to 10-points, 5 points in two sessions. When divided by five, the average loss is 2 points.

In this example, the net gain is 20 points but now you have additional information. Average gains are 6 and average losses are 2 points. Total of average gains and losses is 8 points. It shows that the average gains were significantly higher.

The ratio of average gain in total change in points is 75% (6/8 x 100). That’s RSI.

So, when you look at that chart pattern – you know that the returns are 20-points and the average gain ratio is 75%. The RSI indicator reading is the ratio of average gains to total changes. Hence, it shows the strength of the trend or momentum.

What would be the RSI reading in the following case?

Me: 60%

Yes, the returns are the same 20 points as before.

So, RSI is influenced by the gains and losses distribution which is nothing but a price pattern. Hence, every indicator captures price pattern. In the above instance, the pattern is different, so the RSI reading is different as well.

In our example, we considered a look-back of 5 periods. Normally, RSI is plotted for 14 periods which was suggested by Wilder. RSI measures the ratio of average gain to the total change in a security over a specified period.

I would like to point out that the indicator uses the Wilder average method. However, this example is meant to give you an idea of what the indicator is about.

Me: Yes

You: Now tell me, what does an RSI indicator above 50 convey?

Me: Average gains is more than total changes in the stock.

You: Perfect. It will now be easier for you to understand when you read and listen to people talking about the indicator and the various strategies they explain using RSI.

What does RSI below 30 indicate?

Me: Oversold

You: Hmm

Me: It shows the average losses for the last 14 sessions are 70%.

You: Perfect.

Let’s take an example of a strategy. Price is above 50-day moving average and RSI is above 50.

The 50-day moving average calculates the average price of the last 50 sessions. It also uses the closing price. Moving average smoothens the data. As long as the current price is higher than the average price, it indicates an upward trend.

The trend is downward when it is below average. Take a moment and think about it.

RSI calculates a 14-period average gain ratio.

So, this strategy shows that the 50-period (medium-term) price trend is bullish. And the 14-period RSI above 50 shows strong momentum.

What if in this strategy, you use RSI that is above 30 instead of above 50?

Me: The medium-term trend is up and the short-term trend is turning up. It would be a bullish pullback strategy.

You: That’s right. Understanding the logic behind strategies will help you understand your studies better and it will help gain conviction.

Here’s your homework. Spend time understanding what causes the divergence between price and RSI. Observe the 14-period pattern. That will help you understand what causes it.

Me: We have an indicator on the chart that captures divergence. So why do you have to do all that?

You: I understand, but this exercise will assist you in gaining a better understanding of price patterns and indicators. You can improve your observations and decide your trading strategies accordingly.

Me: Okay.

(The author is CMT, CFTe, MFTA, MSTA. He is the Co-founder & CEO, Definedge Securities)