Introduction
Technical Indicators are a mathematical formula calculated from price data to provide traders with some information that cannot be easily shown from the pure prices like momentum and volatility. Indicators have two major classifications trend-following like Moving averages and Bollinger Band and Oscillators like RSI and Stochastics
What is RSI?
The Relative Strength Index (RSI) is most commonly used as a momentum oscillator, which measures the relative strength between the buying power and selling power over a specific period such as 7, 10, or 14. J. Welles Wilder invented this in 1978. It oscillates around level 50 between 0 and 100. As above 70 called an overbought area And below 30 called an oversold area. If RSI moves above level 70 means that buyers are aggressive, and that might lead to some relief in the price movement due to some profit-taking. Same as if RSI moves below level 30, that means sellers are aggressive, and that might lead to some rallies due to short sellers' profit-taking
How to calculate RSI Indicator?
RSI = 100 – (100 / 1+RS)
RS = Average Up days / Average down days
Average Up Days = Sum of Gains over the past 14 periods / 14.
Average Down Days = Sum of Losses over the past 14 periods / 14
Can you trade just using RSI only?
No, it is just a tool to measure the price movement momentum. Using it alone will give a below-average result.
Trading with RSI indicator
You can not use the RSI signal alone without considering trend analysis because every market phase has a different trading characteristic. In an uptrend, using RSI to time the buy signal will always be the best RSI trading strategy, and in a downtrend, using RSI to time the short signal.
How to trade using an RSI indicator in an uptrend?
During an uptrend, buyers always have control over price movement, and the best trades are always around the end of the downward retracement, where the best risk-reward is present.
1- In a strong uptrend RSI indicator may not reach the oversold area, so when RSI bounces from the zone between 50:35 could be a buying signal, as shown in figure
Figure 1
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2- In a Normal uptrend RSI indicator may reach an oversold area below 30, so the bouncing up from it could be a buying signal, as shown in figure (2)
Figure 2
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When RSI moves above level 70, what we called an overbought area in the uptrend, does not mean it is a good time to sell it means buyers are aggressive, and that might lead to some relief in the price movement due to some profit-taking. So, when RSI bounced down from overbought, it is a good time to take profits for long positions, not to initiate a new short position.
1- In a strong downtrend RSI indicator may not reach the oversold area, so when RSI bounces from the zone between 50:65 could be a sell signal, as shown in figure (3)
Figure 3
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2- In a Normal downtrend RSI indicator may reach an overbought area above level 70, so the bouncing down from it could be a sell signal, as shown in figure (4)
Figure 4
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When RSI moves below level 30, what we called an oversold area in the downtrend, does not mean it is a good time to buy. It means sellers are aggressive, and that might lead to some relief in the price movement due to some profit-taking. So, when RSI bounced up from oversold, it is a good time to take profits for short positions, not to initiate a long position.
How to trade using an RSI indicator in Sideways Movements?
Sideways movement occurs when there is an equilibrium between buyers and sellers, so when RSI bounces down around the overbought area could be a sell signal, and when RSI bounced up around the oversold area, it could by used as a buy signal, as shown in figure (5)
Figure 5
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What is a divergence using RSI?
Most of the time, the RSI indicator follows the price movement, but when it does not, we call this a Divergence which indicates a weakness in the current trend. There are two types of divergence:
1- Positive Divergence
It occurs when the price makes a lower low, but the indicator makes a higher low, it means the current seller is exhausted and lost momentum, and a correction might occur.
2- Negative Divergence
It occurs when the price makes a higher high, but the indicator makes a lower high, it means the current buyer is exhausted and loses momentum, and correction might occur, as shown in figure (6)
Figure 6
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Trading with RSI Divergence
A divergence signal is a mean reversion because the trade takes a position opposite to the current trend. For example, when a negative divergence appears in an uptrend short position could be taken, and when a positive divergence appears long position could be taken because divergence is an indication of a short-term correction. Divergence signals have a 1:1 risk-reward ratio but have a high probability.
Positive Divergence Trade
When RSI shows a positive divergence, wait for any candlestick reversal pattern as a buy signal with stop loss below the candlestick pattern and using BB moving average or 50% retracement level as a target as shown in figure (7)
Figure 7
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A Negative Divergence Trade
When RSI shows a negative divergence, wait for any candlestick reversal pattern as a sell signal with stop loss above the candlestick pattern and using BB moving average or 50% retracement level as a target, as shown in figure (8)
Figure 8
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Conclusion
RSI is one of the best and most stable technical indicators. Still, it is a secondary indicator that is not used isolated from the direction of prices as the trend of prices is the main factor in order to take the signals of the indicator or ignore them. It can give a trend following signals or a mean reversion signal.
The content published above has been prepared by CFI for informational purposes only and should not be considered investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.