What is Relative Strength Index (RSI)?

One of the most used momentum indicators in trading and technical analysis is the Relative Strength Index. Originated by J. Welles Wilder Jr. in 1978, RSI measures the speed and change of price movements and is primarily used to identify overbought or oversold conditions in a market. In this article, we will discuss the basics of RSI, how it is calculated and used by traders to make trades.

Understanding RSI

Relative Strength Index, also called “RSI” is a momentum oscillator that measures the speed and change of price movements It is mainly used to track if a security has been overbought, or oversold. Generally, an RSI above 70 suggests a security is overbought while an RSI below30 indicates that it is oversold. The purpose of these thresholds is allowing traders to pinpoint possible points for a change in direction on the market.

Calculation of RSI

The RSI is calculated using the following formula:

RSI=100−1001+RS 

where RS (Relative Strength) is calculated by dividing the average up closes over x days by the average down closes over x days. The standard number of periods used to calculate the RSI is 14.

Key Concepts of RSI

Overbought and Oversold Conditions

An RSI value greater than 70 is considered an indication that the asset may be overbought and could offer a sell signal. On the flip side, an RSI below 30 would suggest that maybe the asset is oversold and hence giving a good buying opportunity. Nevertheless, these signals are not always accurate and should be combined with confirmation from other indicators.

Divergences

Divergences on the RSI are a sign that price is going in an opposite direction to the RSI. There are differences of two types:

1. Bullish Divergence: Takes places when price makes a new low, but the RSI prints a higher low suggesting that downward momentum was weakening and an upside move might be on its way.
2. Bearish Divergence: This happens when the price creates a fresh peak but its RSI counterpart hits less high-lows, this is hinting that upward bullish energy could be losing steam and thereby transition back into bear side.

RSI Strategies

RSI Reversals

A bullish RSI reversal is a particular type of pattern that traders are searching for evidence on everyday. It can be a good or bad one. A positive RSI reversal occurs when the price of an asset makes a lower low, but the RSI hits from below its prior low. This signal is extremely bullish. On the flip side, a negative RSI reversal occurs when an asset price reaches a low that is less than its previous bottom while at the same time, it's also reaching lower highs on its price chart.

RSI Swing Rejections

Swing rejections, or failure swings as they are sometimes referred to in the literature form a class of itron called swing-wings that work fully on RSI signals and not on price action. A Bullish swing rejection occurs when the RSI drops into oversold, pops above 30, retraces back not making it to oversold and then breaks its previous high. A bearish swing rejection occurs when the RSI enters overbought, falls under 70, rises from there without entering overbought territory and breaks its previous low.

Limitations of RSI

RSI is a mighty tool, but this does not mean that there are no limitations. In strong trends, the RSI can stay in Overbought or Oversold levels for long periods of time and produce false signals. For instance, in a vigorous uptrend the RSI will remain above 70 for some time and might not fall below it even when price begins to turn. Likewise, in a strong downtrend the RSI may remain oversold for an extended period without any kind of price action going to the upside.

Combining RSI with Other Indicators

Traders also tend to use RSI with other technical indicators, such as (MACD) Moving Average Convergence Divergence, so the signals from both can be more reliable. The MACD is a good momentum indicator that can confirm signals given by the RSI. The results are more likely when both indicators agree.

Practical Application of RSI

Example 1: Identifying Overbought Conditions

If a stock has been trending hard up, and the RSI crosses into 70. That is a sign that the stock may be overbought. A trader would take this signal to potentially sell the stock or not make any new buy entries until RSI is back below 70.

Example 2: Spotting Bullish Divergence

When RSI is making higher lows but the price of a crypto coin hits lower low. A bullish divergence of this nature would show that the selling pressure is fading and that a trader could be in for a buying setup, seeking to play before price goes back up.

Conclusion

The RSI is a versatile and most widely used momentum oscillator that identifies the overbought or oversold condition, reversal trade set-up and divergence. RSI is a great tool to utilize but it should be confirmed with other indicators before jumping in. As you can see, by learning about RSI and accurately applying it to the market conditions, traders may be able to make educated decisions in trading that will give them more control over their loss.