What Is the relative strength index?
The relative strength index is momentum oscillator, used by traders as a technical indicator to identify potential buy and sell alerts.
Relative strength index (RSI) is a technical analysis indicator, falling into the category of momentum indicators. American technical analyst, J. Welles Wilder outlined the tool in 1978, presenting it as a means of determining whether assets are overbought or oversold by calculating the speed of an asset’s price movements.
As an oscillator, the RSI indicator can take values between 0 and 100. The indicator can be applied for different time frames with the periods expressed in minutes, hours or days. A shorter period makes RSI more volatile. In fact, Wilder suggests that 14 periods should be used when plotting the RSI indicator.
It is worth noting that the relative strength index is a leading indicator, meaning that it has certain predictive characteristics. It is referred to as an oscillator because it oscillates within defined values.
The indicator is a line within a box- which is usually placed at the bottom of the asset chart. Using the trading platform you plot the RSI indicator on your chart by selecting it from the oscillator indicators category. Bear in mind that it is set by default to 14 periods.
RSI calculation is based on the closing prices for finished trading periods when identifying the asset or market momentum. The calculation assumes that assets will generally have higher closing prices during a bullish movement and lower closing prices in bearish movement. Consequently, the RSI formula is:
RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change)]
You can find a detailed presentation about the way in which RSI is calculated in Wilder’s 1978 book, New Concepts in Technical Trading Systems.
How to read RSI?
The relative strength index indicator can be read based on the relationship between RSI direction and price direction, applying the indicator to determine potential buy or sell signals. When both the RSI and the asset price move in the same direction, the RSI indicator highlights three primary areas which are:
- Overbought area: An RSI value above 70 indicates that the asset is overbought and a downward movement can be expected.
- Oversold area: An RSI value below 30 indicates the asset is oversold and an increase in price can be expected.
- Neutral area: An RSI value between 30 and 70 is considered to be in the neutral zone. In general you should wait for an outbreak in either direction (below 30 or above 70). Follow movements around the centerline for possible crossover alerts.
You can also use the centerline - or the cut-off line, when RSI has a value of 50 - for early identification of potential directional moves. When asset price and RSI are increasing, and RSI crosses the centerline, an upward movement can be expected.
On the other hand, when RSI falls below the 50-line mark, a downward movement might be possible. Nevertheless, this pattern may not be applicable to all asset classes. Hence, maybe it would be wiser if you wait for the above 70 or below 30 signals to appear.
You can use the RSI indicator along with the divergence when you identify movements in opposite directions between the asset price and the RSI indicator. The divergence is applied when you want to determine possible reversals in price movements and you can find a signal for a bullish or bearish reversal. The bullish RSI divergence signal appears when the asset price is decreasing, but the RSI line takes an upward direction. Alternatively, the bearish RSI divergence will show on your chart when the price has an upward direction while the RSI line is decreasing.
How to use the relative strength index?
To use the relative strength index, you should understand how an overbought or oversold condition impacts asset price. When a certain asset is overbought, it is anticipated that the asset is traded at a higher price above its fundamental price. While in a situation of oversold signals, it is anticipated that the asset is traded at a lower price. You should know that RSI trading strategies entail the need for you to understand how you should act when some of the mentioned signals are identified. Primarily you will expect that reversal in trend direction can occur if there is an overbought or oversold signal. The basic guidelines are that:
- During an overbought signal (RSI above 70), you will expect changes in price movements pointing towards a sell action. Depending on the asset you want to trade, you will take a sell position when RSI gets above the 70-line threshold or when the RSI hits the line and starts to move below the 70-line mark.
- You should expect a potential upward price movement and read it as a buying opportunity when the RSI indicators detect and oversold signal.
- You will use the centerline line (RSI 50) when you want to verify that a trend arises. In general, when the RSI indicator crosses above the centerline, then an upward trend is confirmed. On the other hand, if RSI crosses below the RSI 50, a downward trend is expected.
Using the RSI to your advantage entails the need for you to identify potential patterns in the price movement using the overbought or oversold signals. Therefore, when plotting the RSI indicator on your chart, you don't have to stick to the 30 and 70 levels, as an alternative try to adjust these levels in accordance to the specific asset, you can use 20 and 80 thresholds.
You can trade with RSI indicator by complementing it with some other indicators such as the moving average convergence divergence (MACD) indicator, average directional index (ADX), Bollinger Bands or the moving averages indicator. This way, you will be able to confirm the RSI trading signals and remove potentially false signals.
Relative strength index example
Let's look at a couple of examples in terms of the RSI moving in the same direction with the price or when a divergence occurs.
An example when a trader identifies a buy or sell direction based on the overbought or oversold RSI is presented in the following graph.
You can notice that the RSI indicator is presented in a box containing three lines, which represent the three levels, i.e., RSI 30, RSI 50 and RSI 70, also notice that the RSI and the price move in the same direction. In the left half of the graph, it is evident that RSI falls below the 30-mark, signaling a buy action. Contrary to this signal, we identify a sell signal on the right side of the graph when RSI value indicates an overbought state crossing the 70-line mark.
The next graph provides an example of a divergence when a bullish reversal is identified.
From the graph, you can see that the price action and the RSI indicator move in the opposite direction, i.e., while RSI has a higher low (upward movement), the price action exhibits lower low (downward movement). This type of signal determined with the RSI indicator and the price action points toward a possible bullish movement.
RSI indicator advantages
- Can be applied when defining short-term or long-term trading strategies;
- Helps traders to identify potential entry and exit alerts more accurately;
- Can offer an overview of the overall price movement, reversals or trend.
RSI indicator disadvantages
- There is no guarantee that as soon as the RSI line fell below the 30-line threshold or move above 70-line, prices will instantly start to increase or decrease;
- When a strong trend is evident the RSI can provide overbought or oversold signals for a prolonged period, consequently resulting in false signals;
- It is not preferred to use RSI as a standalone indicator.
FURTHER READING: What are Bollinger Bands?
FURTHER READING: How to read trading charts