WHAT IS THE RSI INDICATOR: A COMPLETE GUIDE FOR TRADERS AND INVESTORS

The RSI (Relative Strength Index) indicator is one of the most popular indicators in the world of trading. It was developed by J. Wilder in 1978 and since then it has been the main tool for traders working in various financial markets

Indicator formula and principle of operation

RSI is calculated according to the formula:

RSI = 100 - (100 / 1 + RS)

where RS (Relative Strength) is the ratio of the average value of price growth during a given number of days to the average value of its growth/decline.

RSI compares the average price movement and analyzes how many of the last 14 candles have been bullish versus bearish, and also estimates the size of each candle.

For example, if all 14 price candles were bullish, the RSI indicator would be 100, and if all 14 price candles were bearish, the RSI would be 0. An RSI of 50 means that 7 candles out of the last 14 were bearish and 7 were bullish. The more bullish candles there were compared to bearish candles, the higher the value of the indicator will be.

USE OF RSI INDICATOR BY EXPERTS

The main task of the RSI indicator is to determine the overbought or oversold state of an asset. Knowing the state of the asset in a particular period of time, we are more likely to open a deal in the right direction.

The working area of the RSI indicator consists of values from 0 to 100. It is assumed that values above 70 are considered as overbought and values below 30 are considered as oversold.

It is important to take into account the period of interest, because within a day RSI is more sensitive to price deviations, therefore, for intraday trades it is recommended to expand the area of considered values to 80 and 20. The indicator works best on older timeframes.

WHERE'S THE CATCH? WHY AREN'T EVERYONE STILL MILLIONAIRES?

The point is that overbought and oversold signals do work in most cases, but the indicator may not give signals for a long time, while the price continues to rise or fall.

On the chart above we can see that the indicator set the overbought peak before the price set its maximum - this is called a divergence, we will talk about them further, but now we will pay attention to the fact that the price continued its growth, despite the high overbought indicator.

It is very important to filter RSI signals and use them in synchronization with other chart analysis tools. Overbought/oversold signals alone are not enough to open down/up positions.

Exit from overbought and oversold zones

RSI is multifunctional and it can be used in different ways. For example, there is a more conservative approach, which consists of searching for entries into trades at the moment when the indicator leaves oversold or overbought zones.

On the charts we see that the indicator first went beyond the values of 70. By crossing the 70 mark downward, we get confirmation of the reversal in the downward direction. Thus, we could more accurately determine a favorable entry point, from where the price would more likely go down.

RSI ON DIFFERENT TIMEFRAMES

Setting up RSI in most trading platforms is pretty straightforward. Typically you will need:

1. Open the list of indicators.
2. Find the RSI or Relative Strength Index.
3. Add it to the chart.

Indicator working area

RSI ranges from 0 to 100. Traditionally, if the RSI is above 70, it indicates a possible overbought condition, while a value below 30 may indicate an oversold condition.

Divergence

Divergence is a phenomenon in which the chart of an instrument and the chart of an indicator show different movement.

Schematic example

What does RSI divergence represent?

RSI divergence indicates that the current price direction may be exhausted. For example, if the price reaches a new high and the RSI does not do so, it may indicate a possible trend change.

Types of divergence

There are two main types of RSI divergence:

1. Bearish divergence
2. Bullish divergence

Bearish divergence

Bearish divergence is observed when the instrument price forms a new upper peak, while RSI does not. This may be a harbinger of a future price drop.

Graphic example

Bullish divergence

On the contrary, bullish divergence appears when the price forms a new lower low and RSI cannot overcome its previous low. This may indicate possible future price growth.

Graphic example