The Relative Strength Index (RSI) is one of the most popular technical indicators, if not the most popular of them all. There is virtually no trader that didn’t look at the RSI at least one time, trying to understand what it is standing for.
In one of the previous articles here on ForexGator.com, we highlighted the importance of the RSI and the classical way to interpret it; look for overbought and oversold levels by the time the indicator moves beyond the 70 or below the 30 levels.
Another way to use the RSI is to look for divergences that both price and oscillator are making. These divergences are either bullish or bearish, and, between price and oscillator, the trader should stay with the oscillator all the time.
The reason for this is the fact that the oscillator considers a bigger period before plotting the value. The standard/default period for the RSI is 14, which means it considers the last 14 candles before plotting a value.
However, there are other ways to trade with the RSI, and one is to identify so-called positive and negative reversals. These reversals are used to forecast future market levels or new price objectives for a market.
You’ll find out that a positive or negative reversal is still using a divergence but things are a bit more complicated. The idea behind using positive or negative reversals is to look at price and RSI to react differently in the same context.
The chart above shows the RSI (14) applied on the USDJPY pair and the trend is a bullish one. A positive reversal takes place when between two RSI points, the price is moving to the upside while the RSI is moving to the downside.
This is not a common situation, but it reflects the way the RSI is constructed. If the price is stalling (consolidating), the RSI will move south.
Like the name suggests, a positive reversal is a bullish signal and calls for traders to buy that currency pair. What would be the actual target?
To find out the target, the following things need to be done:
– Find the corresponding price levels for the two RSI points and the highest price level the market did;
– Calculate the difference between the two RSI levels and add it on top of the highest price level in the positive reversal.
Using the logic described above, the three points are represented in the previous chart. The price objective after a positive reversal is forming, can be calculated using the following formula: (2-1)+3.
This effectively means that the result should be added on top of the maximum value in a positive reversal. The corresponding USDJPY values for the three points shown above are 108.77 for nr. 2, 108.02 and 109.54 for numbers 1 and 3 respectively.
Calculating the outcome of the (2-1)+3 equation gives us a projected target higher than 109.54 by 75 pips. That is 110.29.
This way, a target was calculated and this is the result of a positive reversal. In a negative reversal, things are looking exactly the opposite, in the sense that we need to have a bearish trend, and then the RSI should diverge from the price.
As you can see, there is quite a difference between the classical way of interpreting the RSI and this way. While the classical way of using, divergences is more popular among traders, using positive and negative reversals has the advantage of offering a take profit for the trade.
The usual caveat applies in this case as well; the bigger the time frame is, the stronger the signal and the bigger the target and market implications. A positive or negative reversal on the monthly chart shows a continuation of the main trend and buying dips/selling spikes might be the right thing to do.
The fact that such a divergence is forming indicates that the trend is still strong! Trying to fade that trend might be an expecting thing to do.
Therefore, positive or negative reversals are useful even if one is not trading them. Only knowing that such a reversal is forming, should be enough of a sign to warn traders that the trend should continue.
Maybe the name of these reversals is not correct, as the trend continues, but they are extremely powerful tools. Practicing this approach in both bullish and bearish markets will result in fewer reversals that are identified.
The reason for this is the fact that they are not that common like the classical divergences, but this only makes them even more powerful. This way of using the Relative Strength Index may be used on other oscillators as well because oscillators are showing more or less the same thing.
The next article here on ForexGator.com will deal with using oscillators and the Elliott Waves theory, in an approach intended to pick tops/bottoms in both bullish and bearish markets.