The Relative Strength Index (RSI) is among the most widely used trading indicators in technical analysis. It was developed in 1978 by J. Welles Wilder Jr., singled out as “the premier technical trader publishing his work today” by Forbes magazine in 1980. Applied correctly, the RSI can help a trader recognize the signs of overbought and oversold markets. In this guide, you will find out more about the indicator – what is its history, how popular it is today, how to calculate it, what are some other indicators you can combine it with and, most importantly, examples of how you can use it to improve your trading efficiency.
Table of Contents:
- What is the Relative Strength Index – RSI?
- What is the RSI in stock trading?
- RSI indicator buy and sell signals
- Defining the current trend
- RSI trading combinations
- How to calculate the RSI?
- To conclude
What is the Relative Strength Index – RSI?
The Relative Strength Index is an indicator that helps traders capture market momentum by measuring the magnitude of price fluctuations. Traders use RSI to recognize oversold and overbought markets and decide on when to open a position.
Aside from the definition of the relative strength index, a trader should also know how to recognize it on a graph, to be able to apply it successfully. The RSI takes the form of a line between two extremes (also known as an “oscillator”). It can have a value between 0 and 100.
The indicator is applied by technical traders, specialized in trading a wide variety of asset classes, including stocks, FX, futures, etc.
J. Welles Wilder Jr. developed the Relative Strength Index in 1978. The exciting fact about J. Welles Wilder Jr. is that he had no prior financial experience. He is an American mechanical engineer who later switched focus to real estate. This didn’t stop him from turning to technical analysis and becoming one of the most prominent figures in the field.
“Letting your emotions override your plan or system is the biggest cause of failure.”
– J. Welles Wilder Jr.
J. Welles Wilder Jr. introduced the RSI indicator in his famous book “New Concepts in Technical Trading Systems.” He is also the father of some of the most popular technical indicators that are used nowadays. Such are the Commodity Selection Index (CSI), the Directional Movement Index (DMI), the Parabolic SAR, the Swing Index, and more.
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What is the RSI in stock trading?
In its initial form, the RSI was designed for stock trading. As it started proving efficient, traders began applying it to other assets as well.
Over time, though, analysts started assessing stocks by different metrics, including P/E, P/B, valuations, balance sheet analysis, etc. The RSI started flying under the radar, compared to those and other technical and fundamental metrics.
However, the truth is that the Relative Strength Index is an excellent way for a trader to get a fair estimation of the potential of a particular stock. In order to do that, he should know what is RSI in stock trading and how it works.
The RSI is estimated on the scale from 0 to 100. The traditional interpretation of the Relative Strength Index supposes that anything above the value of 70 indicates that the given stock is overvalued and the market is overbought. On the contrary – stocks with RSI below 30 are considered undervalued and their market – oversold. If the RSI is anywhere in the 50% – 70% mark, then the price is deemed to be generally rising. On the other hand, values in the range of 30% to 50% indicate a generally declining price.
How to interpret overbought and oversold signals when trading stocks?
To be able to understand what is RSI in stock trading completely, we should know how to turn the overbought and oversold signals into meaningful actions.
Once we use the RSI to identify an oversold or an overbought stock, then we can expect a trend reversal or a correction and capitalize on it.
Oversold signals suggest that the selling pressure in the given stock is easing, and the traders should brace themselves for an upcoming rebound.
Overbought signals, on the contrary, indicate the momentum when the stock is reaching its maximum levels for bulls and is soon to experience a correction.
Traders who understand what is RSI in stock trading and learn how to apply it will be able to better time the moment to enter or close a position, hedge their portfolios, or relocate their capital to other assets. It is also handy for navigating situations where the stock is trading horizontally, rather than in a particular, clearly visible trend. In some cases, the price may be moving in a narrow band. This makes it harder to predict when a trend will form and whether the bulls or the bears will be in charge. The RSI helps put the price movement in perspective and get a clearer understanding of the whole picture.
What to look for when applying RSI to stock trading?
We have already stated that the RSI is a momentum indicator, which means it helps measure the velocity of a particular asset’s price changes. This, however, doesn’t mean it is indicative of the proportion of the price movement.
Another essential thing is to avoid using the RSI as a self-sufficient indicator. Like any other technical indicator, it has its weaknesses. That is why you shouldn’t base your trading decisions on the RSI solely. Combine it with other indicators, be it technical or fundamental (moving average or stochastic oscillators, for example). The RSI, as an absolute basis, can deceive you, and you may incur trading losses.
Also, you must always look at a broader time frame instead of focusing on a short-term period. Don’t apply the RSI to a limited period like a trading day, for example. Doing so may skew your analysis, which will lead to making losing trading decisions. Traders usually apply the RSI on timetables of 14 periods (some use the RSI in periods ranging from 2 to up to 25 intervals). Bear in mind that, while a longer time frame won’t affect your analysis negatively, a shorter one will.
Last but not least, don’t get deceived by the length of the period an instrument can remain in the overbought or the oversold zone. The RSI can show signs of an overbought or an oversold market for extended periods when the trend is strong.
RSI indicator buy and sell signals
After you already know what RSI is and how it works, let’s focus on how you can apply it in your trading strategy. To do that, we will take a look at some practical RSI indicator buy and sell signals, explore the different situations you can expect, and learn how to trade them.
But to understand the ideas in full, we should, first of all, focus on the terms convergence and divergence. Both terms define a directional relationship between two indicators, trends, prices, etc. Convergence describes the process when they are coming together, while divergence, on the opposite, defines a situation where they are moving apart.
Convergence and divergence are essential when applying RSI as they help reveal the trend’s strength or weakness. When the highs and lows of the RSI move in the same direction with the highs and lows of the trend, then we have convergence, which means the trend is strong and accelerating. When the highs and lows of the RSI and the price move in opposite directions, then the trend is considered to be weaker and slowing down.
Now, let’s see how this affects the RSI indicator buy and sell signals.
Buy signals
We will take a look at three scenarios related to trend reversal and trend confirmation indications. They are all observed during downward market movements.
Bullish oversold signal
The bullish oversold signal is a trend reversal signal that occurs in situations where the RSI falls below 30% and bounces back. There is no difference in how low it will go. The important thing here is for it to rise again above the 30% mark. Once it does, it is an indication that bulls are taking over, and a new upwards trend is forming.
How to trade it? Traders without open positions can go long. Traders who have closed their sell orders already can lock profits and open a buy order.
Bullish (positive) divergence signal
This is another trend reversal signal that occurs when the RSI and the price divert from each other. This happens when the price makes a lower low while the RSI marks a higher low. Depending on the number of times this event repeats, the trader can forecast the strength of the forming signal (the more, the better for the bulls). This comes to show that it is imperative to look at both – the RSI and the price movement.
How to trade it? Traders who spot positive divergence signals should be aware that short-term gains are around the corner. Combined with the indication of an oversold market, this signal is considered a very powerful trigger for buy orders.
Sell signals
Here we will also take a look at three scenarios, indicating trend reversal or confirmation signals. They are observed during upward market movements where the RSI indicates potential selling pressure.
Bearish overbought signal
The bearish overbought signal indicates when a trend reversal is about to take place. To spot such an indication, make sure to look for situations where the RSI surpasses the 70% mark and then falls back below it. Take this as a confirmation that bears are getting stronger, and a trend reversal is about to take place soon.
How to trade it? Traders with long positions can lock their profits and close their open positions so that they can exit the market with a sell. Traders without open positions can consider this signal as a green light to open a short position.
Bearish (negative) divergence signal
Opposite to the bullish divergence signal, the bearish one is observed when the RSI marks a lower high, and the price marks a higher high. Once again, the more repetitive this process is, the stronger the upcoming bearish signal will be. This is another trend reversal signal that confirms the importance of taking into account both the RSI and the price movements and not analyzing any of them in isolation.
How to trade it? The presence of a negative divergence suggests that the trader should expect a short-term decline in the prices of the traded assets. Technical analysts suggest combining it with the overbought signal to get a better indication when you should be selling.
Defining the current trend
Although traders are mostly interested in the way the RSI can help them spot buy and sell signals, it is worth noting that the indicator is very useful also for assessing the primary direction of the current trend and getting a sense of its strength.
Bullish trend alert signal
The bullish trend alert signal is a trend confirmation signal that takes place when the RSI starts rising from the 30% towards the 50% mark. Once you notice this, you will be aware that the buying signal is actually strong. Make sure to rely on it only when observing 14-day or longer periods. When it is applied to shorter periods, the signal may be misleading.
Bearish trend alert signal
This trend confirmation signal can be spotted when the RSI starts falling from the 70% mark towards the 50% level. Once you notice such a signal, it should serve as a confirmation for the strength of the bears in the market. Just like the bullish trend alert, here it is also essential to observe the RSI over periods of 14 days or more.
RSI trading combinations
Although RSI is a useful indicator, it isn’t self-sufficient. To improve your trading accuracy, and build a complete strategy, make sure to combine it with other indicators. That way, you will be able to better validate your trading decisions and dramatically reduce the number of false signals you get while trading. Here are some ideas about possible RSI trading combinations:
Relative strength index and moving average convergence divergence combination (RSI + MACD)
Both indicators can reveal entry signals. When used separately, a part of these entry signals may often be misleading. That is why when you combine the RSI and the MACD, they can confirm each other’s signals. When both indicators’ signals coincide, then it is time to act. An example of such a situation is when the RSI leaves an oversold market and sends a buy signal, while the MACD performs a bullish crossover at the same time. According to the trading strategy’s specifications, such scenarios may require only one sell signal from either indicator, to exit the trade and capture the profit.
Think of the RSI and MACD combination as having Plan A and Plan B applied at the same time.
Relative strength index and moving average combination (RSI + MA)
This is one of the most popular RSI trading combinations. It relies on the overbought/oversold market signals from the RSI and the supporting crossover signals from the MA. When applying the RSI + MA combination, it is crucial to hold your position until either indicator gives an opposite signal or you spot a divergence on the chart.
Here is an example. The RSI for the AAPL stock enters an overbought area. An hour later, it leaves the overbought territory generating a strong sell signal. Thirty minutes later, the moving average marks a bearish cross that reaffirms the sell signal from the RSI. As a result of the match between both signals, the trader sells the AAPL stock before the price enters a strong bearish trend.
If, at the end of the trading session, the trader spots a bullish divergence between the RSI and the AAPL’s price that takes place in the oversold area, he can open a new long position.
Bear in mind that you should avoid basing your trade exit decisions solely on the MA crossover signal.
Relative strength index and relative vigor index combination (RSI + RVI)
Many experts combine the RSI with the RVI in a bid to make more informed and less risky trading moves. This combination requires the trader to wait for a double confirmation, coming from both indicators. Usually, to exit a trade in this scenario, only one signal from either indicator is enough.
Let’s assume that the trader has an interest in buying the Alphabet Inc. stock for Google (NASDAQ: GOOGL). He waits for the RSI to get into an oversold market and give a long signal. Then he waits to see if the RVI will paint a bullish cross. If it does, there is a match between both signals, and the trader can buy the stock. Google starts soaring, and the trader waits for either indicator to give a bearish signal. If, for example, the RVI paints a bearish cross, then the trader closes his position and pockets the profit.
Relative strength index combined with stochastic and moving average (RSI + Stochastic + MA)
This is one of the more complex RSI trading combinations. It consists of three separate indicators and is used mostly by advanced or professional traders. The idea here is the combination to help filter out each of its constituents’ signals and combine them to give a powerful buy/sell indicator. This strategy is applied mostly on 1-hour, 4-hours, and 1-day frames.
To apply this strategy, the trader should use the RSI with its standard settings and set the MA to a period of 10. The Stochastic oscillator should also be at default settings (80/20).
When using this setup, the trader should buy a stock when the price crosses the MA, and when the RSI and the Stochastic oscillators leave the oversold area. The important thing here is to look at the candles where these signals appear. Make sure you’re receiving them in no more than three candles. Otherwise, the signals lose their strength.
When combining different indicators, it is vital to adhere to your initial strategy. If it requires you to wait for two confirmations and a match between signals, then don’t rush. Don’t act on the first confirmation and wait to see if there will be a second one. If there isn’t, don’t trade. On the other hand, if your strategy requires only one sell signal to exit a trade, don’t wait too long, or you risk losing your profits. Discipline here is key.
“Some traders are born with an innate discipline. Most have to learn it the hard way.”
– J. Welles Wilder Jr.
How to calculate the RSI?
The truth is that you can add the RSI to your chart in a few simple clicks. All it takes in Finamark is clicking the Indicator Options icon in the top-middle of your charts.
Select your collection on the left, then click the indicator you’d like to add in the available indicators column in the middle. This’ll add it to your list of active indicators on the right.
However, a trader can’t understand the indicator completely or apply it successfully if he doesn’t know how to calculate the RSI. It is essential that you are aware of the math behind the indicator. Don’t neglect it just because the trading software will do that for you automatically.
RSI calculation
We calculate the RSI on the basis of fourteen consecutive trading sessions. All positive (upward-moving) closing prices are added together. This gives you the value of the upward Exponential Moving Average (EMA). The same is done for the downward-moving closing prices. Now we have the value of the downward EMA.
Then we divide the number of the positive price changes (EMA upward) by the number of the negative price changes (EMA downward) to get the Relative Strength (RS):
As a next step, we derive the index value from the one we calculated for the RS:
The result for the RSI is a value between 0 and 100. By default, the values for overbought and oversold markets are set at 70 and 30, respectively.
However, we should make it clear that, although universally accepted and used by default, some experts raise doubts about their accuracy and propose alternative interpretations for optimal RSI values.
Other interpretations
When it comes to answering the question of how to calculate the RSI, it is worth noting that there are a variety of different interpretations. What is more important is to see what are the proposed results from these interpretations and what is the reasoning behind them.
According to John Hayden and his book “RSI: The Complete Guide”, it is more accurate to set the values for the RSI at 66.66 and 33.33 for bull and bear markets, respectively. He states that these values measure bull and bear trends more precisely and doesn’t take into account the standard extremes.
The movement of the RSI indicator isn’t proportional to the movement of the price. Consequently, technical traders like Andrew Cardwell, suggest that the RSI can prove a quite unreliable indicator when it is around its extremes. That is why he proposes the divergence as a potential entry point in the trend’s direction, rather than against it.
Other traders like Constance Brown, promote the idea that the universal 30% and 70% boundaries aren’t accurate to recognize oversold and overbought markets correctly. According to him, oversold markets should be marked with values much higher than 30%, while overbought markets should be measured way below the 70% mark.
According to some day traders, on the other hand, since some assets are more volatile, it is worth considering using the 80% and 20% levels.
Despite the number of different interpretations, the generally accepted and time-tested standard for the RSI is the 30% – 70% one. That is why it is advisable for beginners to stick to it.
To conclude
The RSI is an extremely useful indicator for several purposes. Whether it is to indicate an overbought (around 70%) or an oversold market (around 30%) or to confirm a trend (moving towards and away from the 50% mark). It is an invaluable part of any technical trader’s strategy.
However, don’t think of the RSI as the “Holy Grail” of trading indicators. In fact, no indicator is capable of significantly improving your trading efficiency on its own. Always use it in combination with other indicators to form a more complete strategy and make more accurate trading decisions. In the case of the RSI, combinations with Moving Average and stochastic oscillators have proven to be working well.
