Momentum Indicators: RSI and MACD

Construction and interpretation of the Relative Strength Index

The Relative Strength Index compares the average size of price gains to the average size of price losses over a specified number of periods, conventionally fourteen, and expresses the result on a scale from 0 to 100. A reading above 70 is customarily described as overbought, indicating that recent gains have substantially exceeded recent losses; a reading below 30 is described as oversold. These thresholds are conventions rather than statistically derived boundaries, and their significance depends heavily on the prevailing market condition.

In a sustained trend, the RSI can remain above 70 for an extended period, in some cases for several weeks on a daily chart. A rule that sells whenever the indicator crosses 70 will, in a rising market, generate a sequence of positions against the direction of the trend. The more accurate interpretation of a high reading is that upward momentum is strong, not that the advance is complete. The overbought and oversold thresholds are most informative in a range-bound market, where price oscillates between defined boundaries and extreme readings tend to coincide with the limits of the range.

Momentum divergence and its correct application

Divergence occurs when price and the momentum indicator move in opposite directions. Bearish divergence is present when price records a higher high while the RSI records a lower high; bullish divergence is present when price records a lower low while the RSI records a higher low. In each case the indicator is reporting that the rate of price change is declining even though the direction of price has not yet altered. This is genuine information about the condition of the trend.

Divergence is not, however, an entry signal for a position in the opposite direction. A trend can continue to advance while divergence persists, and a trader who reverses on the first appearance of divergence will frequently be positioned against a market that has not finished moving. The appropriate response is defensive: existing positions in the direction of the trend may have their stop-loss orders tightened, and further additions to the position may be suspended. A counter-trend position should await confirmation from market structure, such as a break of the sequence of higher lows described in the lesson on trend identification.

Moving Average Convergence Divergence

The MACD indicator is constructed from exponential moving averages. The MACD line is the difference between a faster exponential moving average and a slower one, conventionally twelve and twenty-six periods. A signal line, conventionally a nine-period exponential moving average of the MACD line, is plotted alongside it, and a histogram displays the distance between the two. When the MACD line is above the signal line and the histogram is expanding, the shorter-term average is pulling away from the longer-term average and momentum is increasing.

Because the indicator is built from moving averages, it inherits their characteristics. It lags price, since every average incorporates data from prior periods, and it produces repeated false crossovers in a range-bound market where the two averages intersect frequently without any sustained directional move following. The most informative reading is a contraction of the histogram while price continues to advance, which indicates that the advance is losing pace. This is the same fading of momentum that RSI divergence reveals, observed through a different construction.

Combining indicators without duplicating information

RSI and MACD are both derived from the same price series and both measure momentum. When the two indicators agree, the trader has not obtained two independent confirmations; the same information has been presented twice in different forms. Adding further momentum oscillators to the chart increases visual complexity without increasing the quantity of evidence available, and can create a false impression of consensus.

Genuine confirmation arises when evidence from a different category supports the momentum reading. Market structure indicates the direction of the prevailing trend. A support or resistance level indicates a location at which a reaction is plausible. Volume, or its proxy in over-the-counter markets, indicates the degree of participation behind a move. The higher timeframe provides context for all of these. A momentum indicator then contributes timing and early warning within that framework. An analytical approach that draws one tool from each category is more robust than one that draws several tools from a single category.

• Market structure establishes direction.
• Support and resistance levels establish location.
• Momentum indicators establish timing and provide early warning of a weakening move.
• Agreement between two momentum indicators does not constitute independent confirmation.

Momentum indicators within a trend-following framework

Momentum indicators are most reliable when used in the direction indicated by market structure. In an established uptrend, a decline in the RSI towards the midpoint of its range, followed by a recovery, frequently coincides with the completion of a retracement and offers a lower-risk point at which to enter in the direction of the trend. Used in this manner, the indicator refines the timing of an entry whose direction has already been determined by structure.

The same indicator used to anticipate the end of a trend is considerably less reliable, because trends persist for longer than momentum readings suggest. A trader on the Onys Kapital platform can apply both RSI and MACD to any chart in MetaTrader 5 and adjust their parameters, and is encouraged to test any proposed use of these tools on a demo account, which provides USD 10,000 in virtual funds on the live platform, before committing capital.