The relative strength index, or RSI, is among the most popular indicators used by traders. The RSI provides information about the strength of the price movements on your charts, hence the name. In this article, we will learn what the RSI really does, how to understand the information it provides, and how to use it in trading.
What is the RSI indicator & how to calculate RSI
The standard setting for the RSI is 14 periods, which means that the RSI evaluates the last 14 candles (i.e., time periods).
The RSI compares the average gain and the average loss and analyses how many of the past 14 candles were bullish versus bearish. It also analyses the candle size of each candle.
For example, if all 14 price candles were bullish, the RSI would be 100, and if all 14 price candles were bearish, the RSI would be 0 (or relatively close to 100 or 0). An RSI of 50 would mean that seven of the past candles were bearish, seven were bullish, and the size of the average gain and loss was equal. The more bullish candles, the higher the RSI, generally speaking.
The formula for RSI is 100-(100/1+(U/D)), where U=avg upward price change and D=avg downward price change.
RSI buy signal on RSI chart
The white highlighted area features the past 14 price candles, which the RSI analyzes. Out of those 14 candles, 13 were bullish and only 1 was bearish, which results in an RSI of 85.
RSI sell and buy signals on RSI chart
Here are three more case studies to help you understand the RSI and how it works:
- The first area marks a very bearish period, with 5 bearish candles and 7 bullish candles. The RSI of this period was 84, which signals a bullish phase because the bulls outnumbered the bears.
- The second area features 6 bullish candles and 5 bearish candles, resulting in an RSI of 60, which signals moderate bullish strength, as the balance is equal with just a slight bullish surplus.
- The third area features 6 bullish candles and 9 bearish candles. The RSI of this period was 25, which indicates a strong bearish move because the bears were in control here.
As you can see, just by analyzing the 11 to 15 candles, you can very accurately guess the RSI for a given period. However, using an indicator can still be beneficial because it takes out the guesswork and allows you to process the data faster.
Oversold and Overbought – the myth!
The general idea is that when the RSI shows extremely high or extremely low values (higher than 70 or lower than 30), the price is oversold or overbought. But let’s recap what we have just learned to see if this is really true:
A high RSI simply means that there were more bullish candles than bearish candles, and although the price can’t go on printing only bullish candles forever, it is dangerous to believe that just because the RSI is showing overbought conditions that the price is likely to reverse. Once we understand what the RSI does, we can see that overbought and oversold are NOT signals that indicate that the price will turn.
It’s a myth, and traders show themselves as misinformed when they refer to “overbought” and “oversold” to define markets that will reverse!
The RSI Divergence
Finally, another way of using the RSI to identify turning points is by finding divergences. A divergence signals that the price you see is not usually supported by the underlying price dynamics – we will see what this means now.
Let’s follow the price action and see how an RSI divergence can be a great way of making sense of trend strength.
First, in the image below, we see that the downtrend is strong and clearly defined by lower lows and lower highs. The RSI confirms this by showing a lower RSI when the price fell from 22 to 18, which means that the downtrend was accelerating.
Then, although the price reached a new lower low, we can already see that the price wasn’t able to push as low anymore and just barely broke the previous low. The RSI confirms this by showing a higher RSI and a value of 38, which means that during the last bearish trend wave, the sellers weren’t as strong as they were before.
When the price action and the indicator show opposite signals, it’s called a divergence. A divergence can help us understand that trend strength is fading and that one side of the market participants are slowly leaving the arena.
RSI and MACD
The moving average convergence divergence is a momentum indicator that shows the relationship between two moving averages. It is best used in wide swing trading. MACD uses crossovers, overbought/oversold conditions, and divergences. Using the same concept as moving averages, it is triggered when one line crosses above the other.
In the chart below, the green arrow shows the RSI touching 30, which is a buy signal. The red arrows show sell signals.
On the MACD sector, it is worth noting how the blue line crosses the red one like at the first green arrow, which is a buy signal. The red signal, on the other hand, shows a sell signal.
RSI and Bollinger Bands
This interesting strategy uses a slower RSI with a period of 16 to sell when the RSI increases over 55, or to buy when the value falls below 45. The classic Bollinger Bands strategy to sell when the price is above the upper Bollinger Band and falls below it, and to buy when the price is below the lower band and rises above it. This strategy is only triggered when both the RSI and the Bollinger Band indicators are simultaneously in the described overbought or oversold condition. There are also color alerts, which can be deactivated.
This basic strategy is based on the "RSI strategy" and "Bollinger Bands strategy," which were created by Tradingview and use no money management measures like trailing stop losses and no scalping methods. Every win or loss trade is simply counted from the last overbought or oversold condition to the next one.
RSI and Stochastic Oscillator
The stochastic oscillator is another highly popular trading indicator among professional traders. It is a momentum-based indicator. If its value is 20, that signifies the oversold condition, and if it’s 80, that signals the overbought condition. If its parameter is over 50, that indicates the presence of bullish momentum, and a value below 50 represents bearish momentum.
Coupled with RSI, the stochastic oscillator helps traders either buy or sell parameters.
- The signaling bar closes as a bullish candle
- RSI turns upwards from the 30 level
- The stochastic oscillator bounces upwards from the 20 level
- Hold your long positions when both RSI and the stochastic oscillator maintain their levels above 50 parameters
- Set a stop-loss limit below the respective signaling bar’s low
- Exit your long positions whenever both RSI and the stochastic oscillator turn downwards from the overbought condition levels at the same time
- The signaling bar closes as a bearish candle
- RSI turns downwards from the 70 level
- The stochastic oscillator bounces downwards from the 80 level
- Hold your short positions when both RSI and the stochastic oscillator maintain their levels below 50 parameters
- Set a stop-loss limit above the respective signaling bar’s high
- Exit your short positions whenever both RSI and the stochastic oscillator turn upwards from the oversold condition levels at the same time
Stoch RSI is an indicator of an indicator, making it two steps away from the price. RSI is one step away from the price, and therefore a stochastic calculation of the RSI is two steps away. This is important because, as with any indicator that is multiple steps away from the price, Stoch RSI can have brief disconnects from the actual price movement. That being said, as a range bound indicator, the Stoch RSI's primary function is to identify crossovers as well as overbought and oversold conditions.
When using Stoch RSI in technical analysis, traders should be careful. By adding the stochastic calculation to RSI, the speed is greatly increased. This can generate many more signals and therefore more bad signals in addition to the good ones. Stoch RSI needs to be combined with additional tools or indicators to be most effective. Using trend lines or basic chart pattern analysis can help identify major, underlying trends and increase the accuracy of Stoch RSI. Using Stoch RSI to make trades that go against the underlying trend is a dangerous strategy.
RSI is a great tool, and although you could easily guess the RSI value by looking at the past 14 candles, plotting RSI on your charts can add stability and guidance to your trading. If you can quantify price strength and translate it into interpretable numbers, you can make trading decisions more effectively and avoid guesswork and subjective interpretations.Whether you use RSI to identify strength, to look for turning points, or as a breakout trader, RSI is a universal weapon. To learn more about the overbalance indicators, read the story Overbought and Oversold — Overbalance Indicators in our blog.