Table of Contents
What is RSI?
The Relative Strength Index or RSI is a momentum indicator. Used by technical analysts to measure the speed and change of price movements to evaluate overbought and oversold conditions. RSI oscillates between zero and 100. Conventionally it is considered overbought when above 70 and oversold when below 30.
RSI Indicator provides trader insights about bearish and bullish momentum. And can help a trader identify potential trend reversal The Indicator generally appears at the bottom of the chart.
Calculation of the RSI
Formulae
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
The Formulae Of RSI is very Simple. The relative Strength Index is broken down into its basic components: RSI, Average Gain, and Average Loss. This RSI calculation is based on 14 periods, which is suggested by J. Welles Wilder Jr. in his book. Refer to Wilder’s book for additional calculation information.
Overbought and Oversold
J.Wilder considered RSI overbought above 70 and oversold below 30. But a trader has the liberty of changing these default levels according to the movement of the price. Just like other oscillators overbought and oversold indications of RSI work best when prices move sideways within a range.
RSI Divergence
Divergence is a signal of a potential reversal point. A Divergence occurs when the directional momentum does not confirm the price. A bullish divergence occurs when the price of security forms a lower low and the RSI forms a higher low. Similarly, A bearish divergence forms when the price of security forms a higher high and the RSI forms a lower high. In addition, the Relative Strength Index does not confirm the new high Which indicates a weakness in momentum.
Stochastic RSI
The Stochastic RSI indicator is essentially an indicator of an indicator. This indicator is calculated by applying the Stochastic oscillator formula to a set of RSI values. Through this Indicator, traders can identify whether the current Relative Strength Index value is overbought or oversold. the stochastic indicator is a little more sensitive indicator, due to its use of both momentum indicators.
What is the Difference between RSI and Stochastic RSI?
These Indicators may seem similar at a glance, but Stochastic RSI is based on different formulae. The key difference between the 2 Indicators is their sensitivity in relation to changes in price. The stochastic Relative Strength Index is much more sensitive than the RSI indicator which means that it moves quicker from overbought to oversold levels or vice versa.
From a trader’s point of view, One isn’t better than the other, Both of them provide valuable insights regarding the Trend of the market. Now, If an indicator works better than the other or not, Depends on the trader’s trading Style and Trading Psychology.
How to Trade with RSI
The RSI indicator is one of the most appreciated indicators amongst technical analysts today. However, the Relative Strength Index on its own can not produce consistent and big profits. RSI works best when used within a large trading system, along with other technical tools and indicators, like MACD, Trendlines, Price action, and Moving Averages, etc. You can use these Indicators to confirm Buy and sell Signals of RSI.
RSI Trading Strategies
An RSI Strategy for Day Traders
This strategy is one of the most effective and trustable strategies for Intraday/ Day traders. Firstly, we will have to adjust the default settings of the RSI indicator. There are 2 ways to do that, number 1. click on the list of indicators on your charting software. Select oscillators. . Select RSI. Another way of doing it is to choose ‘Insert’, ‘Indicators’, ‘Oscillators’, and ‘Relative Strength Index. Now change the overbought and oversold levels to 80 and 20 respectively.
Rules for taking up a buy or sell position:
- If the indicator’s line crosses above 80. it is a Sell/Short signal.
- If the indicator’s line crosses below 30. it is a buy/long signal.
RSI and MACD Trading Strategy
MACD is a lagging indicator, and on the other hand, RSI is a Leading Indicator. This makes the combination of both a game-changer. In this strategy, we will confirm the trading signals generated by the RSI Indicator with the help of the MACD indicator. For example, if the RSI indicator is showing an overbought condition, we will confirm this Short signal by a negative crossover of the MACD line (shifting below 0).
RSI with other Technical Indicators and tools
The relative Strength Index is a leading indicator that makes it one of the most important parts of a trading system, Other technical Indicators Such as Moving averages, Trendlines, Candlestick patterns, Bollinger bands, and Fibonacci retracement, etc. have proven to be great confirming tools when used with RSI. Having multiple tools and indicators inside a trading system makes it much stronger and trustable.
Conclusion
RSI is a leading indicator that makes it an important part of a trader’s system. It works best when used in a larger trading system. Even to some critics, it can provide great insights regarding the trend of an asset. And If Combined with the right indicators, the Relative Strength Index forms an efficient system.
Now that you know what RSI indicator is and how to use it Here is an RSI Indicator Cheat Sheet that will help you understand everything you need to know about trading with RSI.
