Moving averages and RSI, the basics
Two of the most common indicators, what they actually measure, and the mistakes that come from reading them as predictions.
Moving averages
A moving average is the average closing price over a set number of periods. A simple moving average weights every period equally, while an exponential moving average gives more weight to recent prices and reacts faster. Traders often watch the 50 and 200 period averages to judge the trend, and watch for price crossing them.
Moving averages lag by design. They confirm trends after they start and can give several whipsaws in a range. They describe what has happened rather than predicting what will happen.
The relative strength index
The relative strength index, or RSI, compares the size of recent up moves with down moves over a period, usually 14, and gives a value from 0 to 100. Readings above 70 are often called overbought and readings below 30 oversold. In a strong trend the RSI can stay overbought or oversold for a long time, so it is a poor reason to fade a trend by itself.
Combining them sensibly
Use indicators to describe the market, not to replace judgement. A common approach is to use a moving average to define the trend direction and the RSI to look for pullbacks in that direction. Test any combination on past data, including the spreads you would really pay, before you rely on it.
Key takeaways
- Moving averages describe trend and lag behind price.
- RSI above 70 or below 30 is a warning about extremes, not a timing signal by itself.
- Test indicator rules on history, including costs, before using them.