How to understand the RSI index

2 mins. to read
How to understand the RSI index

The last twenty years have seen significant growth in the use of technical analysis and charting. The growth of the internet and much more trading by normal retail investors has played a big part in this. As its use has increased, the software we use to try to analyse markets has got ever more sophisticated. On the whole this is a good thing. But I think it can give a false sense of hope to some when it comes to predicting market direction.

Let me explain. Last time around we looked at the simple process of identifying and following trends – the absolute cornerstone of charting for a lot of people. As charting software has moved ahead, the area that has seen the biggest growth has been the section of technical analysis referred to as indicators and oscillators – or as I will often disparagingly refer to them – the squiggly lines at the bottom of the price chart.

Oscillators will take a chunk of the historical price data and crunch it in various ways. Different oscillators will try to show whether a market is overbought or oversold; whether it could be about to start a new trend; whether the price is doing something other than what would normally be expected within the trend; or how volatile the market is now compared to its historical performance. There’s a vast list of oscillators available – it must easily top 100 by now.

When it comes to trying to get market direction right, every little helps of course. But one of the drawbacks of oscillators for the new investor or trader is the belief that if the parameters can be tweaked just so, the secrets of the markets will be uncovered, and untold riches are just around the corner.

You can tell I am just a little sceptical about the value of these squiggly lines. But don’t discount them completely – when used in conjunction with other approaches to market analysis oscillators can definitely help refine the timing of a trade or investment. To introduce the idea we will take a look at one of the most basic types of oscillators – and one that came right at the forefront of this mathematical revolution for crunching data – the Relative Strength Index (RSI)….

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