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Ways to Use the Relative Strength Index (RSI)

The relative strength index, or RSI for short, is one of the most popular technical indicators among the trading community. It belongs to the family of oscillators, or technical tools used to determine overbought or oversold conditions. It’s used to gauge the market sentiment.

 

Developed by J. Welles Wilder, the RSI measures the speed and change of price movements. A popular way of reading RSI values is to look for divergences that occur when a new high or a new low of the price isn’t confirmed by the RSI readings.
 

How it works 

 

The RSI is a momentum indicator. As such, it displays on a vertical range of 0 to 100. Readings close to 0 are viewed as “oversold”, while those closer to 100 are a sign of  “overbought” market conditions. Unlike some other momentum indicators, readings can’t go below 0 or higher than 100.

 

According to Wilder, the relative strength index formula is as follows:

 

RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change)]

 

When the RSI displays readings higher than 70, it means the market is trading in the overbought, or overvalued, territory. On the other hand, a dip below 30 reflects an oversold market condition. 

 

These two levels, 70 and 30, are the default values that can be modified as per the trader’s preferences. Some traders prefer to have values set at 80 and 20 to decrease the number of trips into the overbought or oversold territory and increase the effectiveness of the RSI.

Strengths and weaknesses of the indicator

In general, the RSI is considered to be an effective and useful technical indicator. It generates signals that are used by a trader to paint the full picture pertaining to market conditions. As such, the RSI is the strongest when the market shifts from bullish to bearish periods.

 

The RSI, though, has its limitations and weaknesses, same as any other indicator. Arguably, its biggest limitation is that an asset can trade for a long period of time in an overbought or oversold territory and still continue to make new highs and new lows.

 

For this reason, you should always cross-check signals from the RSI and compare them with other technical indicators. Overbought or oversold market conditions may overlap with signals from other indicators, creating a confluence of resistance/support with enough justification to open a trade. 

 

To illustrate an overbought market, take a look at the EUR/USD daily chart:


EUR/USD - overbought condition
 

The pair had been trading into an uptrend, which makes the RSI cross into the overbought territory above 70. Despite the overbought market conditions, EUR/USD creates three additional bullish candles, pushing the price action almost 400 pips higher from the moment the RSI crossed 70.

 

Experienced traders tend to say that whenever the market is overbought or oversold, it can always be more overbought or more oversold. For this reason, it is not advised to open a trade that is based only on the RSI values, since they generate false signals. 


In order to get more familiar with the relative strength index, its strengths and weaknesses, you may want to use the MetaTrader 5 trading platform. You can access the latest version here. On this platform, you can use the historic price action to analyze the behaviour of the RSI and the signals it generates.

RSI divergence signals

The relative strength index also generates divergence signals, either bullish or bearish. The bullish RSI divergence occurs when the price action creates a new low, or a lower low, while the RSI diverges from the price action and creates a higher high. This way, the RSI leads the price action and it signals that the potential bullish reversal may take place soon. 


On the other hand, the bearish divergence occurs when the price action is still trading in an uptrend, but the RSI has already started to come off the highs. As a result, the RSI signals the impending bearish reversal in the price.

How to trade the RSI

In order to avoid trading the false signals from the RSI, it is advised to cross-check signals against other technical indicators. In the example below, we have GBP/USD trading in an aggressive downtrend, on a daily chart.

GBP/USD - trading the RSI
 

Similarly to the previous example involving EUR/USD, the RSI enters the oversold territory already in the first part of the downtrend. This happens as a result of a strong push lower as the bears completely overwhelm the bulls. As a result, readings are also decreasing in an accelerated fashion. 

 

Our approach, in this case, is to use Fibonacci extensions to identify the 127.2% and 161.8% levels as potential support blocks. As you can see in the chart, a downtrend of around 1,800 pips stops at the first extension level. 

 

Once we see that the bears are losing momentum, and we have a clearly identified level as a key factor for a slowdown, we check the RSI readings to get the confirmation that the market is oversold. 

 

Given the magnitude of the move, you would expect the RSI to trade at extremely low levels. When the price action touches the 127.2% extension, the RSI trades around 15. This is not surprising given that this bearish move pushed GBP/USD towards the lowest levels since 2008.

 

If you go to a monthly GBP/USD chart, you will see that the last time RSI was trending around the 15 mark was in 2008. Although the RSI can always go lower until it reaches 0, a reading of 15 is quite low, especially for the higher time frames.

 

Hence, the RSI is best used as a confirmation indicator. You can also use other technical indicators, such as moving average, Fibonacci retracements, trend lines etc., to identify important levels and then cross-check them with the RSI readings. 

 

In this particular case, we are trading against the 127.2% extension. A stop-loss should be placed below the extension, while a profit-taking order depends on your risk sentiment and risk/reward ratio. 

 

Practice trading of the RSI, and other technical indicators, by opening a demo trading account. This way, you can identify trading opportunities yourself, by applying RSI and other technical indicators to better understand their co-existence, as well as to protect your capital until you feel comfortable to trade live markets.

Summary

The relative strength index is a momentum indicator that identifies when the market is trading in the overbought or oversold conditions. The indicator gauges market sentiment by measuring the speed and change of price movements. As such, it is best used in trending markets, and when mixed with other technical indicators.

 

The RSI also displays bullish and bearish divergences, which happen when a new high or low isn’t confirmed by the RSI readings. Hence, divergences can lead the price action into a reversal, and generate a signal to the trader that the price may change its direction soon.

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