What is RSI?
What is RSI? The Relative Strength Index (RSI), developed by J. Welles Wilder, is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between zero and 100. Traditionally, RSI is considered overbought when above 70 and oversold when below 30. Signals can be generated by looking for anomalies and faulty oscillations. RSI can also be used to identify the general trend.
What is overbought or oversold?
RSI is considered overbought when it is above 70 and oversold when it is below 30. These traditional levels can also be adjusted if necessary to better suit security. For example, if a stock, commodity or currency pair repeatedly reaches the overbought level of 70, you may want to adjust this level to 80. Note that during strong trends, the RSI can remain overbought or oversold for extended periods.
RSI also often forms chart patterns that may not appear on the underlying price chart, such as double tops and bottoms and trend lines. Also look for support or resistance on the RSI.
In an uptrend or bull market, the RSI tends to remain in the 40 to 90 area with the 40-50 zone as support. During a downward or bear market, the RSI tends to lie between the 10 and 60 range with the 50-60 zone as resistance. These ranges will vary depending on RSI settings and the strength of the security or market’s underlying trend.
If underlying prices make a new high or low that is not confirmed by the RSI, this divergence can signal a price reversal. If the RSI makes a lower high and then follows with a downward movement below a previous low, a peak swing error has occurred. If the RSI makes a higher low and then follows with an upward movement above a previous high, a bottom swing failure has occurred.
How does the Relative Strenght Index work?
RSI is similar to Stochastic in that it identifies overbought and oversold conditions in the market.
Readings of 30 or below usually indicate oversold market conditions and an increase in the possibility of price appreciation (upward).
Some traders interpret an oversold currency pair as an indication that the falling trend is likely to reverse, meaning it is an opportunity to buy.
Readings of 70 or higher indicate overbought conditions and an increase in the possibility of prices going down.
Some traders interpret an overbought currency pair as an indication that the rising trend is likely to reverse, meaning it is an opportunity to sell.
In addition to the overbought and oversold indicators mentioned above, traders using the Relative Strength Index (RSI) indicator also look for crossovers.
A movement below the middle line (50) to above indicates an upward trend.
A rising midline crossing occurs when the RSI value crosses ABOVE the 50 line on the scale and moves towards the 70 line. This indicates that the market trend is gaining strength and is seen as a bullish signal until the RSI approaches the 70 line.
A movement from the middle line (50) to below indicates a falling trend.
A falling centerline crossing occurs when the RSI value passes BELOW the 50 line on the scale and moves towards the 30 line. This indicates that the market trend is weakening in strength and is seen as a bearish signal until the RSI approaches the 30 line.
RSI can be used just like the Stochastic indicator. RSI can be used to identify potential peaks and troughs depending on whether the market is overbought or oversold.
What to be careful about?
Most traders use RSI simply by buying a stock when the indicator hits 30 and selling it when it reaches 70. If you remember anything from this article, remember that if you buy and sell based on this strategy, you will lose money. The market does not reward anyone for trading the obvious. Now this doesn’t mean that the simple method doesn’t work, but simple methods that everyone else follows have low odds.
RSI – Trading signals
The RSI provides several signals to traders. In this next section, we will explore the different trade setups using the indicator. Defining the current trend RSI is much more than a buy and sell signal indicator.
RSI can allow you to measure the primary direction of the trend. So how do we do this? First, let’s define the range in which the RSI can track bull and bear markets.
For bull markets you want to be on the lookout for signals from 66.66 and bear markets 33.33. I know this is slightly less than the normal 80/20 or 70/30 readings. These readings of 33.33 and 66.66 were presented by John Hayden in his book entitled‘RSI: The Complete Guide’.
John theorizes throughout the book that these levels are the true numbers measuring bull and bear trends and not the usual extreme readings. I am surprised that more people do not talk about this aspect of RSI. Again, RSI is not just about buy and sell signals.
What about the fact that the indicator is about “strength” and what better use than to measure the strength of the trend. You just want to make sure the stock doesn’t cross 66.66. Should you now buy or sell on signals based on intersections 33.33 and 66.66? Not too fast, there is more to the RSI indicator which we will now dive into.
RSI support and resistance
Did you know that RSI can show the actual support and resistance levels in the market? These support and resistance lines can come in the form of horizontal zones or, as we will illustrate shortly, sloping trend lines.
You may not know this, but you can apply trend lines to indicators in the same way as price charts.
Let’s look at an example where the RSI could call a peak. This is not what you are thinking, as a reading of 90 is a guarantee of a sale.
Distribution of the RSI trend
In this example, the RSI had a breakdown and backtest of the trend line before the price rise. While the stock continued to make higher highs, the RSI started to drop.
The challenging part of this method is identifying when a trendline break in the RSI will lead to a major price shift. As expected, you will have several false signals before the big move. There is no such thing as easy money in the market. It only becomes easy when you have become a master of your craft.
RSI deviation with price
This is an oldie but goldie and is still applicable to the RSI indicator. Based on the example from the last section, identify times where the price makes new highs, but the RSI cannot top itself.
RSI and the broad market
If you want to assess the broad market, I have reviewed an interesting approach to applying RSI to the McClellan Oscillator. Essentially, McClellan measures the forward-looking and decreasing problems of the market.
This does not help you much in your daily trading, as this type of weakness in the broad market only occurs a few times a year. But if you are in the middle of a trade, you can prepare for the coming tide.
It is amazing how applying a strength to a broad market indicator can reveal when weakness reaches a turning point. In addition, I read an interesting post analyzing the returns of the broad market since 1950 after the RSI hit extreme readings of 30 and 70.
In the post, senior quantitative analyst Rocky White highlights that in the short term after a reading below 30, the bears are still in control. But if you look a little further in the medium term, the bulls will show up and a long haul is in play.
Trading strategies using the RSI indicator
Although RSI is an effective tool, it is always better to combine RSI with other technical indicators to validate trading decisions. The strategies that we will cover in the next section of this article show how you can reduce the number of false signals that are so common in the market.
# 1 – RSI + MACD
In this trading strategy, we will combine the RSI indicator with the very popular MACD. We enter the market when we get an overbought or oversold signal from the RSI supported by the MACD. We close our position if any of the indicators give a sell signal.
# 2 – RSI + MA Cross
In this trading strategy, we will match the RSI with the moving average cross indicator. For moving averages, we use 4-period and 13-period MA.
We will buy or sell the stock when we match an RSI overbought or oversold signal with a supportive division of moving averages. We will hold the position until we receive the opposite signal from one of the two indicators or divergences in the chart.
I also want to clarify something about the MA cross output signals. A regular split from moving funds is not enough to exit a trade. I recommend waiting for a candle to close beyond both lines of the moving average cross before exiting the market.
# 3 – RSI + RVI
This strategy combines the relative strength index with the relative energy index. In this setting, we only enter the market when we have matching signals from both indicators. We will hold the position until we get an opposite signal from one of the tools – quite simple.
#4 – RSI + price action trading
Here, RSI overbought and oversold signals are used in combination with any price action, such as candlesticks, chart patterns, trend lines, channels, etc.
To start a trade, we need an RSI signal plus a price action signal – candle sticks, chart pattern or breakout. We will hold each trade until we get an opposing RSI signal or price movement indicating that the move is over.
Which RSI trading strategy?
If you are new to trading, combining RSI with another indicator such as volume or moving averages is likely to be a good start. Pairing with the indicator gives you a definite value for making decisions and removes many of the gray areas associated with trading.
As you have progressed in your trading career, you want to look at methods that use price action that are more subjective, but being able to use techniques that are specific to the security you are trading increases your winning percentages over time. But again, this level of trading takes lots of practice over a longer period.
Example of where the relative strength indicator fails
It is important to highlight where indicators can fail you as a trader and RSI is no different. At best, you can achieve a 60% win rate with any strategy, including one with RSI.
So I’ll lay out the x likely ways that RSI will burn you when trading.
# 1 – The stock continues to trend
The textbook image of an oversold or overbought RSI reading leads to a perfect turning point in the course. However, we all know that things rarely go as planned in the market.
False sell signals
So how do you avoid such an unfortunate event if you go short on the market? Simply, you must include a stop loss in your trade. Get ready, because this will be a common theme as we continue to dissect how RSI can fail you.
# 2 – Deviations do not always lead to course corrections
Divergence – False signals
The tricky thing about divergences is that the reading on the RSI is determined by the price action of the respective swing. Well, there are times when the price action itself changes from impulse to slow. To this point, look at the above chart and notice how after the deviation occurs the stock pulls back to the original break point. But then something happens, the beginning begins to grind higher in a more methodical way.
If you’re long the market, it doesn’t mean you should panic and sell if the high value is replaced by a lower RSI reading. What it means is that you should take a breath and observe how the stock behaves.
If the stock shows problems in the divergence zone, make sure to tighten the stop or close the position. But if the stock blows through a previous resistance level with a weaker RSI reading, who are you going to stop the party?
Extreme readings
In some RSI examples, you see these neat scenarios where the indicator bounces below 30 to backwards above 70.
Well, all you have to do is buy low reading and sell high reading and watch your account balance increase – wrong!
There are times when the ranges are so tight, you can get an extreme reading, but it may not have the volatility to bounce to the other extreme.
So as in the example above, you can buy low RSI reading but have to settle for a high reading in the 50s or 60s to close the position.
How to calculate the Relative Strength Index?
RSI is a fairly simple formula, but is difficult to explain without pages of examples. The basic formula is: RSI = 100 – ? [100 / (1 + (genomsnitt av uppåtgående prisförändring / genomsnitt av nedåtgående prisförändring))]
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