In the pursuit of the ideal trading methodology which is aligned with our unique views and understanding of the market, our trading journeys take in many a twist and turn, full circle loop and ‘aha’ moment.
Exploring different trading styles, methods and analysis techniques is a very natural, yet very necessary part of becoming a rounded and experienced trader.
All traders explore the use of indicators to varying degrees in their journeys, some choosing to use them daily, whilst others preferring to use them occasionally, if at all.
To some, they are a distraction, to others they are an integral part of a trading system and to the rest they provide maybe a visual aid to add an immediate feel for a particular aspect or function of price behaviour.
Most indicators use past price movements as the basis for their calculation and therefore they cannot be perfect predictors of future price behaviour, however, indicators do have many uses and functions which can help traders build a trading approach based on probabilities, depending on what they want out of the market.
One of the most popular groups of indicators are oscillators, which generally move around a central zero line or between maximum and minimum levels and give the user feedback on trend direction and potential change of direction, momentum and trend strength, as well as information which can be used for optimising trade entry timing.
One of the most popularized oscillators used by traders is the RSI - Relative Strength Index.
In this article, we are going to look at what the RSI is, how it works, what it can tell us and how it can be used in trading to our advantage.
What is the RSI…
The Relative Strength Index (RSI) was developed by J. Welles Wilder and published in a 1978 book, New Concepts in Technical Trading Systems.
RSI is a momentum oscillator that measures the speed and change of price movements.
The basics of the calculation is based on the number of gains divided by the number of losses within a given look back period, the default of which, in most packages is 14.
The higher the number of gains in the selected period, the higher the output RSI number.
The RSI oscillates between zero and 100.
Traditionally the RSI is considered ‘overbought’ when above 70 and ‘oversold’ when below 30, however, the terms overbought and oversold are misleading, since in strong trends, the RSI indicator can remain in the overbought and oversold regions for extended periods.
The 50 level can also be used as a guide to trend direction and strength for the period being considered, since if gains are greater than losses within in the calculating period, the RSI value will be above 50 and if the losses are greater than the gains, the number will be less than 50.
Let’s have a look at a few examples.
Figure 1 above highlights the main components of RSI when applied to a chart.
You can see from the far right of the indicator window, the dotted horizontal lines represent the 30, 50 and 70 levels.
The range starts at the bottom from zero to 100 at the top.
The region from zero to 30 is considered the ‘oversold’ region and 70-100, the ‘overbought’ region.
You can see in the chart above, that price changes direction from the 30 level on the far left (green box) and begins to move upwards. As buying momentum picks up, RSI crosses the 50 level from below and confirms a transition to an uptrend.
To start with, buying strength is relatively weak and although RSI remains above the 50 level, it returns to it (first pink box) before major buying steps in causing price to rise sharply and the RSI to head straight into the oversold region, as highlighted by the gold box.
As some initial profit taking takes place, the strength of buying decreases and so the RSI returns slowly to the 50 level (second pink box) before buying interest picks up again, fuelling the continued uptrend.
Note that as price moves impulsively higher (shown by the longer bullish white candles), RSI again hits the 70 ‘overbought’ level.
Some further profit taking occurs, price retraces back to the newer steeper trend line, increased buying pressure again pushes RSI to the ‘overbought’ level, until price finally starts to sell off, leading to a trend line break and a trend direction change, confirmed by the RSI 50 level cross from above to below.
This example is just to illustrate some of the main RSI components and features.
How to use RSI
It is important to note that when RSI hits the overbought region in an uptrend, or the oversold region in a downtrend, it does not mean that price is going to reverse. In strong trends, RSI can spend extended amounts of time in these overbought and oversold regions.
Although not an indication of reversal, RSI reaching the overbought and oversold regions does however warn of an imminent price retracement, but in a strong up or downtrend, really this is a retracement leading to a trend continuation, as can be seen perfectly demonstrated in figure 1.
Whilst overbought or oversold RSI is not a reversal indication, monitoring these periods and identifying divergence, can be a whole different matter.
Let’s consider the above chart example again in figure 2 below.
The appearance of RSI divergence should be immediately apparent.
In figure 2, as price continues to steadily make new higher highs, RSI makes consecutive lower highs, until the third RSI peak (highlighted by the green circle) where RSI starts to fall away even before price starts to drop. This is a great example of how to use RSI.
It’s not in reaction to an overbought or oversold price surge, not even in reaction to the first appearance of divergence, but in the patient monitoring of both RSI and price behaviour at overbought/oversold and divergent levels, until price finally becomes ready to reverse.
The final key reversal level will most likely coincide with a support and resistance level of some kind, whether it be an important price level, pivot level, Fibonacci retracement level, supply and demand level, but even if you are not aware of the level confluence, careful, patient monitoring of RSI and price can lead you to the same conclusion.
Using the 50 level as an indication of price momentum is also worth bearing in mind. Again, it is not in the reaction to the cross, but more in what the cross represents.
The chart in the above example, also illustrates this.
Once price crosses above the 50 level and the uptrend becomes established, the 50 level acts as a support level for the trend. Using this as a consideration, once RSI crosses and remains above the 50 level, you might consider only looking for long entries to get in on the action.
Conversely, as price crosses below the 50 level and a downtrend establishes, you might use that as confirmation to only look for short entries.
In this brief article we have looked at what the RSI is, how it works and how we might use it in our trading.
Monitoring ‘overbought’ and ‘oversold’ RSI price events alongside the emergence of positive and negative divergence, can lead us to price reversals at a very early stage. The 50 RSI level can also be a useful indication of trend direction or price momentum.
Although the 14 period RSI is the default setting in most trading packages, many traders who use RSI will choose the period that suits their style of trading.
For instance, shorter time frame traders, day traders and scalpers, may use the 7 period RSI or less for its more dynamic response to price movements and divergence, whereas longer term traders may prefer the 21 period or above.
It just depends on what you are using the RSI to represent and how it works best for you personally in your trading.
As with all indicators that you choose to work with or investigate, get really familiar with how it responds to different instruments and timeframes. Play with all the settings so that you get a good feel for where the sweet spots and limitations are so that you can exploit them fully in your trading, should they be suitable and effective.
Most importantly, never use an indicator in isolation without considering the bigger picture and what price itself is telling you…after all, all else is derived from it!