Technical analysis is one of the two main approaches to trading the financial markets — the other being fundamental analysis.
But unlike fundamental analysis, which evaluates the economic situation of a financial instrument, technical analysis uses price action and technical indicators to predict the future direction of the instrument.
Technical indicators are developed using complex mathematical calculations, and there are thousands of indicators available to technical analysts and traders.
While new ones are still being developed, most of the old ones are still very much in use, and the Relative Strength Index (RSI) is one of such popular technical indicators used by traders on a daily basis.
In fact, the RSI is among the most widely used indicators for gauging the momentum of price action in any market.
That is why we will be discussing the indicator in this post. The things you will learn include:
- What the RSI is
- How to calculate RSI
- Types of RSI signals
- How to use the indicator in your trading
- Common mistakes to avoid
What is RSI?
Not to be confused with the relative strength — which compares the strength of one market to another — the Relative Strength Index (RSI) is a technical analysis indicator that falls under the category of momentum oscillators.
It is an oscillator that measures the change in price momentum as the price swings up and down.
The RSI indicator line oscillates between the values of 0 and 100.
The indicator was developed in 1978 by J. Welles Wilder, a popular American technical analyst, trader, and author, who is also regarded as the father of other technical indicators, such as the Average True Range, Average Directional Index, and the Parabolic SAR.
In the RSI, Mr. Wilder sought to develop a tool that can determine when a financial instrument is overbought or oversold by comparing the number of times the price closed higher to the times it closed lower.
When attached to the chart, the RSI stays on a separate window below the price chart — the indicator window — unlike certain indicators, such as the Bollinger Bands and moving averages, that overlay the price.
The RSI window consists of a single indicator line and two highlighted horizontal lines set by default at 30 and 70 on the vertical axis, which is normally graded from 0 to 100, Mr. Wilder recommends 14 as the default period, but you can use any number of your choosing.
As the RSI line oscillates between 0 and 100, the direction of the indicator shows the price direction that is gaining momentum — when the indicator is ascending from 0 towards 100, the price is gaining momentum in the upward direction, and when the indicator is descending towards 0, the bears are gaining momentum.
The author considers the region above 70 as indicating an overbought market where the bullish momentum would begin to slow down until the price turns downwards, and the momentum shifts with the bears.
He considers the region below 30 oversold and expects the downward momentum to slow down and finally shift upwards when the price heads up again.
Although the indicator doesn’t naturally have a centerline, some traders do attach a horizontal line at the 50 level.
They believe that the indicator stays above the 50 when there is a strong uptrend, while the indicator staying below the 50 level shows a strong downtrend.
RSI is considered a leading indicator because it tends to give its signal before the corresponding price action occurs.
For instance, the indicator shows when the price is losing momentum in a particular direction before the price reverses.
While the indicator can be used in any timeframe — D1, H4, M5, and others — its signals are more reliable on the higher timeframes.
How is RSI calculated?
The formula for RSI is given as follows:
RSI = 100 – (100 /1 + RS)
Where RS, the Relative Strength factor is the ratio of the Up-Close average to the down-Close average and is given as:
RS = Average Up-Close / Average Down-Close
To get the average of the Up-Closes and Down-Closes, calculate the Up-Closes and Down-Closes first and then get the n-period smoothed moving average of each.
-Up-Close = current price close minus the previous close if the price change is positive, otherwise, the value is zero
-Down-Close = current price close minus the previous close if the price change is negative, otherwise, it takes a zero value
The first average Up-Close is gotten by dividing the sum of the Up-Closes over the past n periods by n.
Similarly, the first average Down-Close is gotten by dividing the sum of the Down-Closes over the past n periods by n.
The subsequent averages are calculated from the previous averages and the current Up-Close or Down-Close as follows :
- Average Up-Close = [(n – 1)(previous Average Up-Close) + current Up-Close] / n.
- Average Down-Close = [(n – 1)(previous Average Down-Close) + current Down-Close] / n
With these, you can now calculate the RS and the RSI using the formulas above.
It’s fine if you don’t understand the calculation as the charting platform does that automatically — just be sure you know how to set it up on your chart.
As we stated before, most charting platforms have the default period setting at 14, but you can choose a different value to suit your style and preferences.
Note that the longer the period, the more smoothed the RSI value, and the fewer and more reliable the signals.
Types of RSI signals
There are different types of signals generated by the RSI, each of which can be used in different trading strategies.
Traditionally, the RSI is known for the divergence and overbought/oversold signals, but over the years, traders tried out other methods of using the indicator and came up with the RSI centerline cross and the RSI trend line breakout. Let’s discuss the four of them in detail.
The RSI was built primarily to show when the market is overbought (too expensive that the buying pressure would soon start slowing down) or oversold (too cheap that the selling pressure would soon start declining).
The author used 70 and 30 levels to identify the overbought and oversold regions respectively, but you can choose different levels, such as 80 and 20.
The market is said to be overbought when the RSI line climbs above the 70 level.
This means that the market is at or close to the peak of buying pressure, and a price correction is expected in the nearest future.
So, an overbought signal has a bearish implication.
However, the price going into the overbought region is not really a bearish signal as the price can stay in that region for as long as possible.
What really constitutes a bearish signal is the RSI climbing down below the 70 level from the overbought region.
On the flip side, when the RSI line falls below the 30 level, the market is considered oversold.
The implication is that the market is nearing the peak selling point, and the price may soon start to rally. In other words, the bulls may be about to strike.
But you should know that the price can remain below the 30 level for as long as it can, so falling into the oversold region is not an indication to buy.
An RSI oversold bullish signal only occurs when the indicator line is climbing above the 30 level from the oversold region.
RSI divergence signal
RSI divergence occurs when the price swings and the RSI line are not moving at the same pace such that when one is making a lower swing low, the other is making a higher swing low and vice versa.
RSI divergence is considered a better signal than the overbought/oversold signal. Depending on where the RSI divergence occurs, it can have a bullish or bearish significance.
A bullish divergence is one that forms at the end of downswings or swing lows.
It occurs when the price is making a lower swing low while the RSI is making a higher low, in which case it is called a classical bullish divergence, or when the price is making a higher swing low while the price is making a lower low — a hidden bullish divergence.
The classical bullish divergence is seen at the end of impulse waves in a downtrend, where it may herald a temporary price rally or a full-blown trend reversal.
It can also occur in a deep pullback with multiple legs during an uptrend. The hidden bullish divergence usually occurs with pullbacks in an uptrend but may also occur at the right shoulder of an inverse head and shoulder pattern at the end of a downtrend.
A bearish divergence occurs at the end of upswings or swing highs. It is formed when the price is making a lower swing high while the RSI is making a higher high or when the price is making a higher swing high while the price is making a lower swing high.
The former is referred to as a hidden bearish divergence, while the latter is known as classical bearish divergence.
A hidden bearish divergence usually occurs with pullbacks in a downtrend but may also occur with at the right shoulder of a head and shoulder pattern at the end of an uptrend.
The classical bearish divergence often occurs at the end of impulse waves in an uptrend, where it may herald a temporary pullback or a full-blown trend reversal. It can also occur in a deep pullback with multiple legs during a downtrend.
RSI centerline crossover
Some traders attach a horizontal line at the 50 level to create a centerline for the indicator.
When the indicator rises from below the centerline to above it and surging towards the 70 level, it is called a rising centerline crossover.
It shows that there is an uptrend, and it is increasing in strength. This is seen as a bullish signal until the indicator turns downward after entering the overbought zone.
In other words, if you want to trade an uptrend, check whether the RSI is above the 50 level.
On the other hand, when the RSI line falls below the 50 level and heading towards the 30 level, it is known as a falling centerline crossover, and it indicates that the market is weakening in strength or there is an outright downtrend.
Thus, an RSI movement from above to below the centerline is seen as a bearish signal until the indicator heads upward again after entering the oversold region.
If you are about to trade a downtrend, it may be wise to first confirm whether the RSI is below the 50 level before going ahead with the trade.
RSI trend line breakout
Connecting the RSI swing points with a trend line can show a trend in the indicator. If the indicator is showing rising lows, connect the lows with an ascending trend line.
When the indicator line breaks below that trend line, it might mean that the price is about to turn downwards.
On the other hand, connecting the RSI highs when the indicator is showing descending highs will give a descending trend line.
An upward break of the RSI downtrend line might mean that the price is about to head upwards.
Being a leading indicator, an RSI trend line break will likely precede the corresponding price action on the price chart.
How to use the RSI in your trading
Now that you have seen the different signals the RSI indicator can generate, let’s see how we can make use of them in picking good trading opportunities in different market conditions.
While some may be good for trading a ranging market or pullback in a trend, others may be more useful for trading a breakout.
Trading a ranging market
A ranging market is one in which the price is held up between two boundaries — an upper boundary and a lower boundary.
The upper boundary forms a resistance zone as upward price swings reverse around that level, while the lower boundary serves as the support zone since downward swings tend to reverse there.
Being a momentum oscillator, the RSI can be very useful in trading a ranging market because as the price swings between the upper and lower boundaries of the range, the RSI oscillates between the overbought and oversold regions.
Expectedly, one of the RSI signals you can use to trade a ranging market is the overbought and oversold signals.
An overbought signal is the RSI falling below the 70 level from the overbought region, and it’s a bearish signal.
The oversold signal is generated when the RSI rises above the 30 level from the oversold region, and it is a bullish signal.
Another RSI signal, which may even be more accurate than the overbought/oversold signal, is the divergence signal. It can be bullish or bearish divergence.
Here is how to trade a ranging market using the RSI :
-Identify a ranging market and attach the RSI to your chart
-Wait for the price to reach any of the boundaries
-When the price is around the lower boundary, look for an RSI oversold region signal or a bullish divergence, and when at the price is around the upper boundary, look for an RSI overbought signal or a bearish divergence
-Enter a trade on the close of the candlestick when the signal appeared
-For a long position, put a stop loss below the lowest point of the downswing, and if it’s a short position, put a stop loss above the highest point of the upswing
-Put your profit target just before the opposite boundary — before the upper boundary for a long position and before the lower boundary for a short position
Breakouts are some of the most interesting opportunities to trade because they often come with big momentum and occur quite commonly.
The price can break out of anything — a consolidation, support or resistance level, chart pattern, or trend line.
A breakout occurs when the price closes beyond the structure it’s trying to break.
While some traders trade the breakout alone, considering only the price action, others use other tools to confirm the likelihood of the breakout to be successful.
The RSI centerline cross can be used to confirm a breakout trade. For an upward price breakout, a rising RSI centerline crossover may help you confirm the trade.
If the price makes a downward breakout, a falling RSI centerline crossover may be good confirmation.
Here is how to trade an upward price breakout with the RSI:
- Be sure the main trend is up
- Wait for the price to close above a resistance level, a trend line, or any other structure
- Check whether the RSI is above the 50 level
- Go long if everything aligns
- Put a stop loss below the preceding swing low
- You can ride up the trend with a trailing stop
When trading a downward price breakout, these are the steps to follow :
-Ensure it’s a downtrend
-Wait for the price to close below the corresponding structure — support level, trend line or any other
-Confirm the RSI is below the 50 level
-You can go short if everything aligns and a stop loss above the preceding swing high
-Ride the trend with a trailing stop if you want or put a profit target acccordingly
Trading pullbacks in a trend
You can also use the RSI to trade a pullback reversal strategy in a trending market.
In such situations, the RSI signal serves as a trade trigger when the price has pulled back to a key price level.
The RSI signals that can be used to trade pullback reversals are the overbought/oversold signal and the divergence signal.
Sometimes, the RSI trend line breakout may also be used.
Those signals show when the pullback has lost momentum, and the price is about to start a new impulse wave in the trend direction.
Since they are occurring at a key price level, the chance of a successful outcome is high.
Some of the tools you can use to identify key price levels are the trend lines, support and resistance levels, Fibonacci retracement tool, and long-period moving averages.
To trade pullbacks with the RSI signals in an uptrend, these are the steps to follow :
-Confirm that the price is in an uptrend with an uptrend line or a long-period moving average
-Wait for a pullback to reach the trend line, moving average, Fibonacci retracement level, or a support level — a confluence is better
-Confirm a trade setup with an RSI oversold signal or a bullish divergence — combining with candlestick pattern is great
-Go long and place your stop loss some pips below the swing low
-Either place a profit target at the next resistance level or Fibonacci expansion level, or ride the uptrend with a trailing stop
These are the steps you can follow when trading pullback reversals with RSI signals in a downtrend :
-Use a trend line or a long-period moving average to confirm there’s a downtrend
-Allow the pullback to reach the trend line, moving average, a Fibonacci retracement level, or resistance level — a confluence is better
-Look for an RSI overbought signal or a bearish divergence — combining with candlestick pattern is great
-Put a sell order and place your stop loss some pips above the swing high
-Ride the downtrend with a trailing stop or place a profit target at the next support level or Fibonacci expansion level
Mistakes to avoid when using RSI
These are two common mistakes to avoid :
-Using the RSI alone: The RSI only gives signals; you need to combine with tools that show key price levels.
-Not waiting for the signal candlestick to close: An RSI signal is not valid until the candlestick with which it is formed is closed.
RSI is one of the popular trading indicator developed by J. Welles Wilder.
It is an oscillator that measures the change in price momentum and can generate four different signals — overbought/oversold, divergence, centerline crossover, and RSI trend line breakout — which when used with other tools, can yield high probability trade setups.