HOW IT WORKS: RSI (Relative Strength Index) Indicator

The RSI is a popular momentum indicator used in technical analysis. It was originally developed by a mechanical engineer turned technical analyst J. Welles Wilder Jr.

It was first published in a 1978 book, “New Concepts in Technical Trading Systems” and in Commodities Magazine (Futures magazine) in June’s 1978 issue.

Today the RSI is one of the most popular indicators used to measure the speed and change of price movements.

In other words, it measures the strength of its trend direction (up, down and sideways) on any market by monitoring the changes in its closing price.

THE MAKE UP

The RSI is a line graph that moves between two extremes…

On the vertical axis (Y-Axis) the RSI line moves up and down in a range between 0 and 100.

NOTE: As the indicator is between a range, it is considered a closed indicator.

On the horizontal axis (X-Axis), the RSI line moves to the right which is plotted as time.

NOTE: You can choose your own time frame i.e. days, hours, minutes etc…

For all you technical boffins…

If you want to know how the RSI is calculated, I’ve saved this at the end of the article.

As a trader you won’t need to worry about the maths at all.

Three trading signals you’ll use with the RSI

1. Overbought and Oversold levels
2. Patterns and Trend lines
3. Bullish and Bearish Divergences

Trading signal 1:
Overbought and Oversold levels

When we see the market’s price move up, this means the buyers are outweighing the sellers.

And the more higher closing prices we see, on a market, the higher the RSI line moves…

When we see the market’s price drop, this means the sellers outweigh the buyers.

And the more lower closing prices we see, on a given market, the lower the RSI line moves…

However…

If the buying continues at an unsustainable rate, the RSI will reach a point that traders call OVERBOUGHT (top heavy).

This is where we could start to expect the price to drop from these levels and for the market to enter into a correction (dip).

If the selling volume continues at an unsustainable rate, the RSI will reach a point that traders call OVERSOLD (undervalued).

This is where we could start to expect the price to turn up from these levels and for the market to enter into a recovery (upside).

Now that you understand overbought and oversold terms, let’s explain what I mean with the RSI chart.

Overbought RSI: 70 (Sell opportunity)

When you see the RSI line touch or cross above 70 (Red horizontal line), this is considered an overbought situation.

At this point, traders may start to anticipate that the rising trend is about to end.

Traders may then start to prepare to sell and short their positions, as they believe the market’s price has run up too much.

If the market then turns down and starts to drop in price, the RSI line will drop below 70 and head back to equilibrium at 50 (Black horizontal line).

Oversold RSI: 30 (Buy opportunity)

When you see the RSI line touch or cross below 30 (Green horizontal line), this is considered an oversold situation.

At this point, traders may start to anticipate that the falling trend is about to end.

Traders may then start to buy (go long) their positions, as they believe the market’s price has dropped too much.

If the market then turns up from the 30 mark and starts to rise in price, the RSI line will move back to equilibrium at 50 (Black horizontal line).

Trading signal #2:
Trend lines & Patterns

The second way to spot buying and selling trade ideas is with trend lines and patterns.

Uptrend confirmation

To confirm the strength of the market’s uptrend, you should be able to draw a support (floor level) under the high low RSI prices.
And when the RSI breaks below the support line, it could signal the end of the uptrend and a start to the next bear market.

Downtrend confirmation

To confirm the strength of the market’s downtrend, you should be able to draw a resistance (ceiling level) over the lower RSI high prices.

And when the RSI breaks above the resistance line, it could signal the end of the downtrend and a start to the next bull market.

These are great confirmation and reversal trading signals to use with your strategy.

NOTE: You can also base your buy or sell ideas on trading chart patterns…

Trading signal #3:
Bullish & Bearish Divergence

The third signal I use to spot trade opportunities with the RSI is looking at the market’s price VERSUS the RSI’s direction.

In short…

BEARISH DIVERGENCE – Warning for downside

If the markets price makes higher lows, while the RSI makes lower highs – it’s a warning for DOWNSIDE to come.

BULLISH DIVERGENCE – Sign for upside

If the markets price makes lower highs, while the RSI makes higher lows – it’s a signal for UPSIDE to come.

Either way with both bullish and bearish divergences, the RSI fails to accept the current market’s price movements.

And so it is making a probability prediction that soon the market will make a reversal in its current trend.

Ok so now you know how the RSI works. Let’s sum up what we learnt.

RSI Summary in 3 Trading Signs:
Trading signal #1:
Overbought & Oversold levels

Overbought zone X > 70 = Selling opportunity
Neutral zone: X = 50
Oversold zone X < 30 = Buying opportunity

Trading signal #2:
Trend lines & Chart patterns

Uptrend confirmation: RSI makes higher lows (draw support line)

Downtrend confirmation: RSI makes lower highs (draw resistance line)

Breakout confirmation: RSI breaks out of a chart pattern

Trading signal #3:
Bullish & Bearish Divergence

Bullish divergence: Market’s price – lower highs
RSI – higher lows

Bearish divergence: Market’s price – higher lows
RSI – lower highs

Here’s how to calculate the RSI

The most common (default) settings for the RSI is 14 (Which we’ll use))

There is a two-part calculation with the RSI.

Part 1: Calculate the RSI (step 1)

RS or Relative Strength is (Average Gain ÷ Average Loss)
Average Gain = (Sum of gains over the past 14 periods) ÷ 14
Average Goss = (Sum of losses over the past 14 periods) ÷14

Calculate the RSI (Step 1)

Part 2: Calculate the RSI (Step 2)

Once you have this result, we then smoothen the RSI result with part 2…

And so that’s how the RSI continues with each closing price of the time frame you choose.

Trade well, live free.
Timon
(Financial trader since 2003)