J. Welles Wilder was the man behind the Relative Strength Index (RSI) indicator. He described the tool in his book titled ‘New Concept in Technical Trading System,’ which was released in June 1978. It is an indicator that traders use to check the speed and change of the price of a financial asset (which can be a forex pair, stocks, and other securities). The idea behind using the RSI indicator is to measure how quickly traders are bidding a security’s prices up or down.
What is the RSI trading formula
J. Welles Wilder also described the RSI trading formula in his book, and a breakdown of the formula is written below:
RSI = 100 – [100/(1 + RS)]
RS stands for Relative Strength = Average gains/Average losses
- How to calculate for 14 days period (which is usually the default RSI setting)
Let’s say that the market closes with an average gain of 2% in the first seven days, and the next seven days closes with an average loss of -0.9%
We will have: RSI = 100 – [100/(1+ 2.22), and with proper calculation, the RSI would read 68.9%, which means the price would be just a little below the overbought line of 70%
Then a 14 days market data is used to compare the two results, and when the two calculations are combined, it forms a more accurate RSI reading. It compares the previous gains and losses to the current ones, and it is calculated thus:
RSI step 2:
- Avg. Gain = [(previous avg. gain) x 13 + current gain]/14
- Avg. Loss = [(previous avg. loss) x 13 + current loss]/14
Taking the prior value with the current value makes the result smoother, which means that RSI values become more accurate.
How to trade using the RSI indicator
The RSI indicator is made up of a single line that fluctuates between 0 to 100. There are three primary zones in which the RSI is divided, and they are:
Oversold zone: 0 to 30
Neutral zone: 30 to 70
Overbought zone: 70 to 100
The RSI gives different information about the market as it moves around the zones, giving traders opportunities to profit. The RSI gives different market signals. Since it is a leading indicator, the signal it gives can come before the actual price moves depending on the information provided.
According to the RSI zones described above, the RSI indicator gives different signals according to the position it occurs. These signals will be described below:
- The overbought signal
The market can be said to have been overbought when the RSI line enters into the 70 to 100 zone. This signals a possible reversal or retracement of a bullish move. Suppose a trader is in a buy position. In that case, this might be a point to be careful with the trade, protect his profit, opt out of the market, or expect a minor retracement before the bullish move continues.
- The oversold signal
The market becomes oversold when the RSI enters into the 30 to 0 zone. When the price is oversold, the price is likely to reverse. At this point, a trader is either expecting a retracement before the bearish move continues or reversal. He might also seek to protect the profit already made.
- Divergence signal
Relative Strength Index divergence occurs when the RSI indicator diverges from the overall price action. This gives information that a reversal might happen in the market. RSI divergence can be of two types; they are bullish RSI divergence and bearish RSI divergence. In the bullish RSI divergence, the price in the main chart is decreasing (selling), while the RSI line is increasing (buying). This is usually an indication of a strong bullish signal. On the other hand, the bearish RSI divergence happens when the price in the main chart is increasing while the RSI line is decreasing. It is usually a solid bearish signal on the chart.
- Placing trades using the RSI
To enter a trade with an RSI signal, you need to have seen a signal on the RSI indicator (which might be any of those that has been described above), such that when you are entering an overbought signal, you are looking at a selling position when it is an oversold signal you should be looking at taking a buying position. If it is a divergence, you will be looking at following the direction of the RSI indicator, whether a bullish or a bearish direction. But be patient to see the chart also forming an opposite price action before having your trade entry.
- Placing stop losses using RSI
It is necessary to set stop losses after placing trades since no trade has an assured outcome. It is better to place the stop loss beyond the swing low or swing high (as the case may be) created at the reversal point.
- Setting take profit
It is generally believed that a trade should be held till you get an opposite RSI signal, then you can take your profit. But in the practical sense, you should protect your profit when necessary as nothing is certain in the market.
- RSI on long term trends
Even though many traders use the RSI for short-term trades, it could also be used on higher time frames like the weekly and monthly timeframes to predict the direction of the market. It is possible to enter short-term trends with long-term trends. For example, suppose the monthly RSI is oversold and gives a possible buy signal. In that case, it might be reasonable to look for a buy entry on a daily chart. Suppose the monthly time frame is already overbought. In that case, a sell signal in the daily chart might be the beginning of a bearish market move.
It is also worth noting that the RSI indicator cannot give a consistently profitable strategy in isolation. The RSI should be used with other indicators or price action to form a good trading strategy. The RSI trading indicator will give many false signals. Using it alone as a trade entry strategy will only lead to losses. This article will further explain other indicators that could be used with the RSI to form a profitable trading strategy.
Which indicator works best with RSI?
Many indicators work with the RSI. The decision of which is the best indicator depends on the trader’s perspective and strategy. The important thing is to note that the RSI indicator could be combined with other indicators. The RSI could be used with the MACD, trendline, Bollinger band, moving average, and other indicators. An example of how it could be used with the moving average will be explained below:
- Moving average (cross overs) and RSI
There are two typical moving averages: the simple moving average and the exponential moving average. The simple moving average is the average price over a defined number of periods. In contrast, the exponential moving average gives more weight to recent prices.
The moving average can be used to confirm the information gotten from an RSI indicator. Exponential moving average responds faster to price changes. When there is a moving average crossing, it can confirm a situation of an overbought or oversold market. Short-term moving averages like 8 EMA and the 14 EMA can be used to confirm a price reversal. Suppose 8 EMA crosses below the 14 EMA. In that case, (when the RSI is showing an overbought signal) affirms that the RSI is overbought and a possible reversal is imminent, and vice versa. The moving average crossover works well with the RSI when it is an upward trend or a downward trend, but it might lead to losses if used in a ranging market.
The blue line in the chart above shows where the 8 EMA (the white line) crosses the 14 EMA (the blue line), signalling a trend change. At the same point, the RSI is only below the 50 value line, signalling a shift in trend.
Determining the trend using RSI
Asides from using the RSI to determine whether the price of an asset is overbought or oversold, the Relative Strength Index can also be used to know the direction of a trend.
A trend is the movement of price over some time. The direction of the trend could be upwards, downwards, sideways (rightward). It happens many times that the price of a particular instrument might differ on different timeframes. For example, the daily chart of GBP/JPY might have an upward move, while the 4 hours chart might be moving rightward, and at the same time, the 15 minutes chart might be a downward trend. This might pose a difficulty for traders when trying to identify the trend on a particular time frame. It could be very dangerous to trade against the trend, and professional traders have devised many means of identifying the trend in a market using the RSI. One of the ways will be described below
- Change the parameter in your RSI settings
The default RSI trading setting has two lines, which are the 30 and 70 lines. You should remove the 30 and 70 value lines and replace them with 50 value lines. This way, the indicator oscillates around the 50 value line.
- Determine the trend by the 50 value line
The trend is up if the RSI indicator trends above the 50 value. This is a confirmation that the price is bullish. Note that the RSI line should not just be a little above the 50 line, as that would only count as a weak bullish signal.
The trend is down if the RSI indicator trends below the 50 value line. This confirms that the price is bearish, and the trader should be on the lookout for possible sells. As it is for the upwards trend, when the price is only dwindling below the 50 value line, it is a weak downward trend.
When the trend is sideways (consolidating/ range-bound), the RSI line will be seen trending close to the 50 value line and moving within the 40 and 60 value lines.
This simple strategy can be used to determine the direction of the market, and getting the direction of the market can increase the profitability of a trader.
Some RSI trading strategies
Selling when the price is overbought and buying when the price is oversold will not work if used alone. It will only lead to losses and frustration in the market. There is more to using the RSI than just buying and selling at oversold and overbought positions.
Market price being overbought/oversold doesn’t mean that the chart will reverse immediately. The price might remain in such positions for days. Some RSI trading strategies are described below.
- Combining RSI with support and resistance levels
An RSI level at 70 means nothing, but an RSI at that level that also meets the price at a significant area of resistance can be an opportunity to sell successfully. We can example from a situation where there is a price breakout from a strong support zone, and then the price goes for a retest. When such retests happen and coincide with when the price enters into an overbought position, it might be a good time to sell.
This can also work for a buy position, in a case where the price breaks a critical resistance level and then goes back to retest. When the retest point also coincides with an oversold position, it might be a good point to buy.
- RSI divergence
The RSI divergence was described above, and it is one way to make a profit in the market. You should not enter a trade just because you saw an RSI divergence. When a divergence occurs, you should wait for confirmation. Such confirmation could be a break of the trend that is expected to change. As written earlier, divergence can be bullish or bearish.
- Moving average crossover
The moving average crossover described above is also an excellent strategy to combine with the RSI. It is generally noticed among professionals that a high moving average value works better than the short moving average. This is not to force the use of longer timeframes on anyone (as was seen in the crossover explanation above, a shorter time frame was used), as your trading success is very dependent on using strategies that you understand correctly.