In trading, there are 2 main indicator categories: trend indicators and oscillators.
The 1st one is used to confirm the trend of a financial asset. Trend indicators are thus better used in directional markets, as they don’t provide much information when markets evolve within a range.
The oscillators are used to capture reversal points, as they display overbought or oversold situations. These situations are shown when readings of the oscillators reach certain levels. These types of indicators will be more relevant during trading ranges or non-directional markets to anticipate reversals.
Why I’m telling this?
J. Welles Wilder developed the “Relative Strength Index”, commonly called the “RSI”. It’s a popular indicator of the oscillator technical indicator family. Oscillators evolve in a range. In the case of the RSI, the range is between 0 and 100.
This article will help you understand this indicator and will explain how it can be implemented in your trading strategy.
What is the RSI indicator?
Market analysts frequently use a handful of indicators, such as MACD, Moving Averages, Ichimoku, Volume, and the RSI. The Relative Strength Index is widely used as the oscillator that displays temporarily overbought or oversold situations. Spotting extreme situations can inform traders that a retracement could happen soon.
Here’s how it goes:
The RSI measures the relative changes in higher and lower closing prices. To compute the RSI, use the following formula:
1. Choose a predetermined period n – the default value is n = 14
2. Compute “RS” = the average of the n bullish closing values / the average of the n bearish closing values
3. RSI = 100 – (100 / (1 + RS))
It’s easier than you think.
Also, your trading platform will do all the computing work. It will then display the RSI indicator in the bottom part of your chart, as shown in the following chart.
The indicator is composed of a single fluctuating line. Volatility spikes can affect the quality of the trading signals, as they can push the indicator to increase or fall sharply, thus providing false indications.
Therefore, it’s wise to add other indicators as a complement to RSI.
For example, often traders will add an exponential moving average to the RSI to improve the quality of trading signals.
How to use the RSI indicator to trade overbought/oversold levels
The RSI indicates that an asset has reached an overbought level when the value of the indicator is above 70.
When the RSI reading is below 30, it shows an oversold level. Readings above 85 are considered as a strong overbought situation and a possible selling signal.
If the RSI falls below 15, it’s considered to be a strong oversold situation, and a potential buying signal.
However, trading is more complex than just selling when it’s in the overbought area and buying when it’s in the oversold area.
So what’s the secret?
An oscillator is also here to tell you that the trend is simply slowing down – that prices are losing momentum. It doesn’t mean that they will reverse.
Look at the rectangles in the following chart. They only show a very short break in the current upward trend.
How to use the RSI indicator to confirm a trend
You can also use the RSI to determine the trend of a financial asset. You can use the indicator to confirm trend formations by analyzing whether the RSI is above or below the 50-level.
Allow me to explain:
If you think that a possible uptrend is happening, make sure that the RSI is above 50. In the case of a possible downtrend, look for a RSI below 50.
On the chart below, you can see 2 examples where the RSI was used to confirm the formation of a downtrend (red circle) and an uptrend (green circle).
Just before the red circle, you can see that the BNP Paribas broke the bullish trend line, then formed lower tops – the prices then lose momentum. The share had twice tested the support level at EUR 54.80 before breaking it – see red circle.
But here’s the kicker:
The breakthrough is made with a long red candle, which confirms the strength of the bearish movement. At the same time, the RSI crosses below the 50-level, and you can see the downward leg that follows.
Now let’s move on:
Just before the green circle, the stock forms higher lows after reaching the lowest level on the chart. Prices tested the EUR 40.24 resistance level but couldn’t break through.
However, the 2nd test was successful, with prices breaking the resistance line with strong green candles, gaining upward momentum. At the same time, the RSI crossed above the 50-level, and you can see the upward leg that follows.
How to use RSI Divergences
The RSI indicator is a great way to spot divergences, as it’s a powerful way to identify potential market reversal opportunities.
This can be done by comparing the evolution of the indicator and the asset.
If they aren’t evolving in the same direction, or “diverge”, then there is a divergence.This could mean that prices might reverse.
How To Use RSI With Other Indicators
RSI and MACD
Remember that the MACD (Moving Average Convergence Divergence) measures the momentum of an asset by comparing 2 moving averages.
Let’s have a look at the MACD indicator:
A buying signal will only be considered as such when the MACD line crosses above the signal line, and the opposite as a selling signal. After that, we will look for a confirmation from the RSI indicator. We will have a confirmation of a buying signal when the RSI leaves the oversold area.
Now get this:
Conversely, we will have a confirmation of a selling signal when the RSI exits the overbought area. Another selling signal could be if the RSI enters the overbought zone, if the MACD has already generated a selling signal.
RSI and Moving Averages Crossovers
Remember that Moving Average (MA) crossovers are tools to identify points on the chart when the slow MA passes above or below the fast MA, and vice-versa. This indicates that the current trend might be about to change. Traders can use these areas to enter or exit the markets.
How to combine them?
Moving Average crossovers can be used to confirm overbought/oversold situations where prices could reverse. When the shorter MA (blue line) breaks below the longer one (purple line), then prices tend to go down.
Conversely, when the blue line breaks the purple line, then prices tend to reverse and go up. This is what is displayed in the rectangles in the above chart. The vertical lines also show that, while an MA crossover is happening, the RSI is leaving the overbought/oversold area.
This is how you can use both indicators together.
You may also notice that the RSI usually provides an early indication of a potential trend change. This is due to the fact that Moving Averages are lagging indicators.
RSI and Bollinger Bands
Standard deviation is a simple measure of volatility. As a consequence, when volatility increases the bands widen. Conversely, when markets are more quiet, the bands contract towards prices.
Overbought and oversold situations can also be spotted with Bollinger Bands:
When prices are on (or above) the upper band, this means that the asset is overbought. When prices are on (or below) the lower band, then the asset is said to be oversold and prices can reverse. While using both indicators, signals are confirmed when both indicators signal extreme overbought/oversold situations.
RSI Indicator – Summary
- The RSI (Relative Strength Index) is a very well-known oscillator developed by J. Welles Wilder.
- It fluctuates between 0 and 100 to provide overbought/oversold situations. Readings above 70 indicate that prices might be about to reverse downward, as they are overbought. Readings below 30 indicate that prices might be about to reverse upward, as they are oversold.
- Do not automatically sell when an asset is overbought, or buy when it is oversold, as the indicator can simply show when the asset is losing momentum. The indicator can sometimes provide false signals, as it doesn’t necessarily indicate a reversal.
- RSI = 100 – (100 / (1 + RS))
- Unlike trend following indicators, oscillators are used to identify “extreme situations” that may lead to reversals.However, they have a relatively short predictive capacity, so it’s better to use them for short-term strategies, such as scalping or day trading.
- One of the most common uses of this indicator is to identify divergences. RSI divergences happen when prices are moving in one direction, but the RSI is moving in the opposite direction.
- You can use the RSI with different indicators. The most common trading strategies using the RSI with another indicator are the RSI combined with MACD, Moving Averages, Bollinger Bands and Ichimoku.