The Relative Strength Index is one of the most common, yet most powerful, tools in any trader's toolbox. I personally use the RSI indicator a lot to act as evidence to further enforce my trading predictions. The RSI indicator can be applied to a wide variety of trading circumstances and has such a variety of use cases that this section is likely to be quite lengthy but very important.
The RSI indicator is a momentum oscillator. What does this mean? Simply put, the indicator measures a change in price over a specific period of time resulting in an indicator which oscillates around 100. It compares the magnitude of recent gains to the magnitude of recent losses and turns that into a number between 0 and 100. The RSI has a higher value when the average gains throughout the specified period are higher than the average losses. The calculation for RSI is:
Average Gain = Total Gains/Total Period
Average Loss = Total Losses/Total Period
Relative Strength = Average Gain/Average Loss
RSI = 100 - (100/(1+Relative Strength))
The most common period for RSI to be calculated is 14, as recommended by J. Welles Wilder, its creator. This means the RSI is calculated using the price action of the previous 14 candles. He also recommends using the 70 and 30 levels as an indication of overbought and oversold market conditions. These levels are widely accepted although they might occasionally be altered to suit an individual's particular style of trading i.e. 80 & 20 if they are particularly conservative.
The RSI can be applied to any time frame, the principles stay the same. Altering the RSI period (recommended 14) will alter the volatility of the indicator. A shorter period will create a more volatile RSI whereby, price rapidly fluctuates from overbought to oversold. A longer period RSI will cut out a lot of the noise to give a smoother, less sensitive indication of the market condition.
RSI Use Cases
RSI is commonly used to identify overbought and oversold areas in the market. A market is considered oversold if the indicator dips below 30. It is considered oversold if it peaks above 70. These areas are labelled as "overbought" and "oversold" for a reason. The RSI indicator is designed to identify strong moves in the market, whether bullish or bearish. These strong, sudden price movements in one direction are usually unsustainable and therefore, they're likely to result in a move in the opposite direction, known as a correction (if small) or reversal (if larger trend is reversed). Therefore, when price exceeds the 70 RSI level, it indicates that the market is overbought and a move to the downside should be anticipated. When price drops below the 30 RSI level, it indicates that the market is oversold and a move to the upside should be anticipated.
It is important to wait for further confirmation when using momentum indicators such as the RSI as they can produce false signals. So, instead of selling as soon as price enters the oversold zone, a trader might wait for price to move below the overbought (70) condition and this could be taken as a bearish signal. The opposite is true if price moves above the oversold level (30), this could be considered bullish. As mentioned previously, this indicator should be used in conjunction with other market analysis techniques. For example, if the overall trend is bullish, a trader might look for an oversold (RSI = <30) condition before looking for a reason to enter a long position (buy).
I personally do not use the RSI indicator alone to enter into trades. I use this indicator as another filter to analyse the market in order to determine the potential direction of the next move (bullish or bearish). If multiple filters indicate the same market conditions or direction, only then should you be looking for reasons to enter a trade.
This is the most important aspect of the RSI indicator, so pay attention and take notes.
RSI Divergence can be described as a situation whereby price and RSI are moving in opposite directions. Therefore, price is moving higher but RSI is moving lower. Divergence indicates a slowdown in the momentum of a price movement. So if RSI is moving lower but price continues to rise, this indicates that price is rising at a slower rate than it was previously. This means that the buyers have lost power and a correction or reversal might soon occur. Divergence does not occur every time a change in trend is about to happen, but when it does, it can be used as a strong confirmation signal. The reason these signals are so powerful is because they occur before the trend change occurs. This gives you an enormous edge over the market as you are essentially given an indication of price movement before it begins, allowing you to enter a trade at the beginning of a move, maximizing profit potential.
Bullish divergence occurs when price forms lower lows but RSI forms higher lows (see examples below). This is particularly effective if the RSI lows are below the 30 level. When this occurs, it might be a good idea to start looking for reasons to enter a long position or "buy" the market. This is likely to come in the form of certain candlestick patterns (see candlestick analysis for more information).
Bearish divergence is the same as bullish divergence but in reverse. So, price forms higher highs whilst RSI produces lower highs (see examples below). This is particularly effective if the RSI highs are above the 70 level. Again, if this occurs it is likely to be a good time to start to look for reasons to enter a short position or "sell" the market based on candlestick patterns.
This is where things get a little more complicated. The "normal" bullish and bearish divergence described above are the most common and most powerful forms of RSI divergence.
Where regular RSI divergence indicates potential trend reversals, hidden divergence indicates potential trend continuation.
Hidden bullish divergence occurs as price creates higher lows, but RSI shows lower lows (see examples below). This means that price is in an up trend but sellers have entered the market and tried to push price lower with a strong, sudden price move. This price move is not significant enough to make lower lows on the price action chart but it is volatile enough to produce lower lows on the RSI. As mentioned previously, this volatility, or sudden change in price, is not sustainable and therefore, the sellers are exhausted and price moves higher as buyers take control of the market.
The opposite is true for bearish divergence. Price creates lower highs but RSI creates higher highs indicating that the buyers are exhausted and therefore, sellers are taking control of the market.
RSI is one of the most popular and important indicators used by traders today. It is a momentum indicator used to quantify the size and speed at which the market has shown recent gains/losses, throughout a specific period of time. The common period used for the RSI indicator is 14. I personally use this 14 period as a standard. Occasionally I will use the 7 period for an overview of more recent price action and in-depth analysis. On the contrary I also use the 30 period for larger patterns (usually harmonics) in order to reduce "noise".
This indicator is most commonly used to identify oversold and overbought market conditions. The 70 and 30 levels are the recommended areas used to identify these conditions. The 80 and 20 levels are also used however, these levels are rarely hit unless the market is experiencing extreme price action/volatility.
RSI divergence is a major tool to avoiding false signals and can be particularly useful to identify areas at which to enter the market. I do not recommend using the RSI alone as a reason to enter a trade. RSI should be used as evidence to indicate potential market direction. Entry reasons should come in the form of candlestick patterns, alongside particular RSI conditions i.e. divergence.
RSI Divergence Explained. Print this off and include it in your trading plan for reference!
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