Introduction
It is almost natural at this point for anyone who has engaged with stocks to come across the Relative Strength Index, or RSI, sooner or later.
And, in a world like the stock or cryptocurrency markets, where you have every type of indicator for every little situation, it’s hard to not consider the impact left by the RSI.
J. Welles Wilder Jr. is the person behind it, and he introduced it all the way back in 1978 in his seminal book titled “New Concepts in Technical Trading Systems.”
What is RSI (Relative Strength Index)?
So what is the RSI all about anyway? Well, it’s a momentum indicator that’s used within technical analysis, measuring the magnitude and speed of a stock’s latest price changes to assess undervalued or overvalued conditions regarding its price.
As for how it’s displayed, it’s done as an oscillator, or a line graph with a scale of 0 to 100.
The Purpose of RSI (Relative Strength Index)
The entire purpose of RSI is to basically point out whether securities are overbought or oversold. Not only that, but they also indicate whether securities are primed for a corrective pullback or trend reversal.
In other words, they can generate trading signals that can indicate when to sell or buy, i.e., an instrument that can measure momentum, which traders could then use to their benefit.
How is RSI Calculated?
You must have had a fair idea of what the RSI is about now, so you might want to know how it is calculated and what the values really mean, which is what we’ll look at below.
Default Settings
Hence, readings below 30 indicate buying opportunities, which implies that assets are undervalued. In contrast, RSI readings that land above 70 indicate selling opportunities, implying that the assets are overvalued.
Obviously, a reading of 50 shows a balance between bearish and bullish sentiments, i.e., a neutral stance.
As for the formula itself, used to calculate the RSI, it’s as follows:
RSI = 100 – [100 / {1 + (Average of Upward Price Change / Average of Downward Price Change}]
Within the calculation, the average percentage loss or gain is measured over specific periods. Losses are treated as positive values within this formula.
In that look-back period, periods containing price losses are considered to possess zero average gain, while periods with price gains are considered to have zero average loss. Generally, though, 14 periods are used in the calculation of the initial RSI value.
How to Use RSI in Trading
Now that you know a bit about RSI readings and what they could mean, you might want to shift your attention to what you can do with the RSI whenever you’re trading.
Overbought and Oversold Conditions
The common approach basically involves buying when conditions depict oversold and selling when stocks are overbought. Aggressive counter-trend traders instantly enter once the RSI readings get above 80 and below 20.
Other people simply wait until the slowing down of that original trend or until things tick in the opposite way. Others yet wait until the RSI leaves the overbought or oversold area and heads back to normal levels.
While borders like 20 and 80 tend to be the most popular, don’t let that stop you from using anything else. Some people use 70 and 30, or even 90 and 10. You may use anything you want; in fact, even something like 82.2 and 17.8.
Generally speaking, though, the lower the border for oversold and the higher the border for the overbought area you select, the lower the likelihood of the market getting behind, with your RSI giving fewer trading signals.
RSI Divergence
RSI divergence basically happens when the RSI indicator begins to reverse before the price does. A bearish divergence contains an RSI reading of overbought, and a lower high on the RSI then follows.
Simultaneously, on its second peak, the price has to make an even greater high, where you have a lower RSI. Within a bullish divergence circumstance on the RSI, you must have an oversold condition, and a higher low follows on that RSI graph.
At the same time, the price has to generate an even lower low on its second peak.
Another, easier way you can look at RSI divergence is that the RSI can display changes in price momentums prior to you witnessing changes in prices.
You may consider it as a sort of early warning signal. Either way, once you have gotten the signals for either bullish or bearish divergence, you must start planning your trades accordingly.
RSI Trendlines
On the RSI oscillator itself, two valleys or peaks, at least, are connected, and this is how those trendlines are drawn. So, for instance, an uptrend RSI trendline is drawn by linking higher swing lows on that oscillator itself.
Conversely, within a downtrend, the RSI trendline is made by linking lower swing highs. A trading opportunity presents itself when an RSI trendline has been broken.
When that RSI shifts direction, that’s basically a leading signal that displays the possibility to cause a substantial move within the market.
All in all, the RSI trendline break can be a strong indicator. If you’re trading a stock or a cryptocurrency even in the trend’s direction, then you may use that trendline break as this trigger, whereby you may exit your trade.
Conversely, should you be trading against that trend, a trendline break could then become a trigger for you to make a trade.
RSI Strategies for Different Trading Styles
Outlined below are just some of the different trading styles more commonly used and how the RSI indicator can relate to them.
Day Trading with RSI
For day trading, since traders are typically looking for some short-term gains, they can adjust the time frames accordingly and set their midpoint level to 50.
Swing Trading with RSI
Since swing trading focuses on medium- to long-term gains, that standard 14-day time frame would suffice, and they could then use the divergence strategy as a means to make some profits, which we already discussed earlier.
Long-Term Investing with RSI
As for long-term trading, they can adjust the timeframe for the RSI as they see fit and draw trendlines to identify any extreme conditions that they could subsequently benefit from.
Advantages and Limitations of RSI
But like any other indicator out there, the RSI does have its own share of flaws that warrant mentioning. as we’ll discuss below, after going through the benefits first, that is.
Benefits of Using RSI
So, what does the RSI get right? Well, for starters, it’s a great tool for gauging momentum and whether an asset is overbought or oversold, something that’s integral to a lot of traders’ strategies.
Because of this, it’s no wonder that you see it being one of, if not the most widely recognized, indicators out there.
Limitations of RSI
But what are some things that it doesn’t get right? Well, firstly, the potential for false signals is still there. Secondly, it’s not exactly the tool for every kind of market out there in that it’s more fitted for markets that trend, not the choppy, sideways ones.
And finally, it’s a lagging indicator, which means that in rapidly changing markets, it may not present accurate signals.
Conclusion
The RSI, short for relative strength index, is one of the most well-regarded technical indicators, aiding traders in finding out some possibly good purchase entry points, like when a stock is oversold, and selling points, such as when a stock is overbought.
Not only that, but it’s watched frequently for divergence signals of potential upcoming trend changes. Still, that doesn’t necessarily mean that it’s without its fair share of faults, and those have to be kept in mind so that you can make up for them.
What is a good RSI level for buying?
Anything below 40 should be good; the lower the better, but you must not really wait that long for the price or RSI level to get that low since you never know when they might bounce back up again.
Can RSI be used in all asset classes?
Not every single asset, literally speaking, but a fair amount, and even cryptocurrencies, which are considered by many to be a type of security anyway.
What is RSI divergence?
RSI divergence is basically when the RSI indicator goes in what initially appears to be an opposite route of the prices. However, a lot of the time, it’s an indication of what’s to come, a sort of early warning signal that the market is due for either a correction or a recovery.
Is RSI effective in trending markets?
Yes, it is! In fact, a lot of people would say that it’s made for them.
How can I avoid false signals when using RSI?
Well, you may pair it with another trading signal, like the MACD, short for the moving average convergence divergence. Then there are moving average crossovers, smoothed RSI, long-term RSI, and a ton more. With this, you’re essentially getting that extra pair of confirmations, which can be beneficial.