Confirming Signals With RSI
I recently wrote an article about The Three Most Profitable Stock Chart Patterns and it’s become so popular that I thought I’d follow it up with this article.
If you trade on one indicator alone, you will get burned. The markets tend to be fickle and no indicator is 100% effective. Stock patterns are nice because they’re easy to recognize and have a reasonably high level of accuracy. However, since technical analysis is based on probabilities, it’s prudent to have at least one way to confirm price direction. Using the right indicator(s) to confirm your predictions can increase the probability of a successful trade.
That’s where RSI comes in.
RSI stands for Relative Strength Index. The formula takes into consideration the average number of an underlying security’s up days vs. its down days in order to determine an overbought or an oversold condition.
Some traders will use RSI to enter or exit positions based on whether the security is overbought or oversold. The strategy seems easy enough, but that strategy has never really worked for me. I find that RSI is much more valuable in confirm signals rather than generating signals.
Here’s and example:
You can see that the price of USD/CAD looks like it hit a double top. A quick glance at RSI shows that the currency pair is losing strength. A divergence like this is a very powerful signal that a trend could be ending.
Here’s what happened to USD/CAD:
Not a bad little move huh?
There are hundreds of technical indicators. Some help you find trends, some indicate entry and exit points, and others work well for confirming signals. While chart patterns can provide good signals, you’ll need to have some way of confirming them if you want to improve your success ratio. For that purpose, RSI works well.
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