Reading an RSI chart

As with many technical indicators, RSIs are much easier to digest in chart form. In Figure 11-9, the lower chart is a daily six-month long chart on Intel, (symbol INTC). The top section of the chart is a basic candlestick chart depicting the price action in Intel stock from July to December 2007. Numerous bullish and bearish candlestick formations are charted on this chart, but for now, just focus on the RSI component.

In the bottom quarter of the chart in Figure 11-9, there's a slow-moving line that depicts the RSI. This line is normally how an oscillator is depicted on a chart. Unlike a moving average, which is imposed on top of a chart's price component, the RSI (or any other similar indicator) appears below the price component. Note how the RSI seems to flow along and mirror the movements of the closing prices. However, at times the RSI either flattens while the price continues to move or even moves in the opposite direction. This change is called a divergence.

Divergences are the key to using the RSI, and a divergence combined with a corresponding candlestick pattern that matches the direction of the divergence can provide you with a profitable trade signal.

But the RSI's usefulness doesn't end with its role as a momentum indicator. RSIs may also be used as signals that reveal when the price of a security has reached a level that's too high or too low for the near term, or a level where a reversal of trend is more likely.

The simplicity may sound too good to be true, and of course, it is. Using the RSI by strictly buying when it hits 30 or selling when it hits 70 is a disastrous strategy. It does make for a good rule of thumb, however, when you consider it alongside a signal from a candlestick pattern or a divergent move in the RSI relative to the price chart.

Combining a divergent RSI with a candlestick pattern is a smart move, and adding the overbought or oversold levels into the equation is even smarter, and can provide you with much more reliable buy and sell signals. The strength of the RSI as both a momentum and oscillating signal is why it's one of my personal favorite indicators.

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