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Using WildersВрRSIВр for ВрDay Trading

The relative strength index (RSI) was originally developed by Welles Wilder. In the early 1980s when I was on a seminar tour of the Far East with Welles and a group of other traders, he was just beginning to develop his applications for the RSI. Since then there have been many applications of the RSI, all of which have potential, but many of which will not generate profits for the day trader.

The RSI is a price-based oscillator. It has many applications both as an index of overbought/oversold market conditions and as a timing indiВэcator. Of particular importance to day traders is the first derivative RSI which tends to smooth the indicator, thereby resulting in fewer false sigВэnals and greater accuracy in day trading.

Before discussing the first derivative of RSI as a day-trading indicator, I will explain the raw RSI indicator as traditionally used by futures traders. This understanding is necessary in order for you to differentiate between my suggested applications and the application commonly used by contemporary futures traders.

In many respects, the RSI is similar to stochastics in that it is used as an oscillator. Subsequent to extremely high readings, a sell signal is indiВэcated when RSI begins to decline. Conversely, a low RSI that begins to increase in value while prices are low is a buy signal. There are many different applications of RSI.

Since the RSI lends itself equally to many different interpretations, I won't claim here that my suggested methodology regarding the use of RSI is unique. I do feel, however, that my first derivative application is a unique implementation of RSI. Figure 8-1 shows RSI application along with my comments.

Defining the First Derivative

Don't let the term first derivative scare you into thinking that complicatВэed mathematics is involved. In fact, it is not. The first derivative of any variable is defined as

A quantity derived through the mathematical manipulation of a previous quantity.

In other words, as this relates to the futures markets, consider the folВэlowing: If I calculate the RSI in a given market, and if I then use the RSI as the raw value for calculating a moving average of the RSI, then the second calculation, namely the moving average of the RSI, is the first derivative of the RSI. If I calculate an RSI of the moving average of RSI, then I have calculated a third derivative of the RSI. Figure 8-2 shows an RSI plotted against its first derivative.

My work with timing indicators as well as derivatives of timing indiВэcators has convinced me that such manipulation of the data can be very effective in terms of generating meaningful and less random timing sigВэnals. Although there is insufficient space here to launch into a discusВэsion of indicator derivatives and their comparisons, I would urge you to undertake such studies on your own. You may be impressed, as I have been, with the results.

A first, second, third, and fourth derivative, and so on, then, are quanВэtities derived from previous indicators which are themselves derivatives of other indicators or raw prices.

Let me give you a concrete example of what I mean by a first derivaВэtive of the RSI. Figure 8-3 shows an intraday market with a 14-day RSI indicator plotted against price. Figure 8-4 now shows the same indicator plotted against price, however, also included is the first derivative of RSI. As you can see, the derivative line is smoother, less choppy, and therefore, in my opinion, more readily usable by futures traders. Figures 8-5 and 8-6 show two different derivatives of RSI plotted against the same price chart. Examine these if you will, and reach your own concluВэsion, strictly based on visual observation, as to which of the three might have potential as a timing indicator.