Contents of this article
Combining an oscillator (the RSI) with a trend indicator is the usual approach when building a trading system. This article, however, offers a different perspective: using the RSI on its own, together with basic charting concepts, to make effective trading decisions. Like many other minimalist traders, I tend to use very few indicators on my charts, and the RSI is one of the indicators that works well for swing traders.
What is the RSI indicator?
The RSI (Relative Strength Index) is a momentum indicator used in technical analysis to measure the strength of price, developed by J. Welles Wilder in 1978.
Like many other indicators, it uses price data as its input and has one variable that can be adjusted to suit real-world conditions. RSI(x) uses the price data of the previous x candles as its input. The most common value of x is 14 (RSI(14)).
The RSI formula is as follows:
From the formula above, we can see that:
- The RSI can only take values between 0 and 100.
- The midpoint (50) occurs when total gains equal total losses over x sessions, indicating a sideways trend.
- If the most recent trend is up, the indicator will be between 50 and 100; otherwise, it will be between 0 and 50.
The RSI is closely tied to a stock’s gains and losses, so it is classed as a momentum indicator. To borrow an idea from physics, the RSI can be thought of as the acceleration of the price chart. When price has more up sessions than down sessions over a given period, the RSI will be high, signalling strong upward momentum, and vice versa. Let’s look at some applications of the RSI in stock trading.
Using the RSI to identify overbought and oversold levels
As mentioned above, a high RSI reflects strong buying pressure and a low RSI signals a downtrend. When the RSI reaches a certain high level, usually > 70, it is considered “overbought” – implying that prices have risen too often, warning of an unsustainable advance and a possible bearish reversal soon. Conversely, when the RSI reaches a certain low level, usually < 30, it is considered “oversold” – implying that prices have fallen too often, warning of an unsustainable decline and a possible bullish reversal.
However, an RSI below 30 does not always mean we should buy. An oversold stock is not guaranteed to rebound in the near future. The example below shows the RSI staying in oversold territory for a long time while the stock kept falling.
So when you use overbought and oversold zones to find buy and sell points, the best buy points come when the RSI rises and confirms its exit from oversold territory. The best sell points come when the RSI falls and confirms its exit from overbought territory. This strategy works best in a sideways market.
In a trending market, the best thing to do is trade with the trend and not fight it. For example, when a stock is in an uptrend, you can look for buy points based on the RSI’s oversold zone, but you should not use overbought readings as sell points. In addition, a buy point has a higher chance of success if price is at a strong support zone.
Trading RSI divergence
Normally, a rising stock price should be accompanied by confirmation from momentum (the RSI should rise too), and conversely, when price falls, the RSI should fall in step with it. There are exceptions, however, and these are called divergences.
In the example below, price breaks above its previous high and confirms the uptrend, but the RSI fails to make a new higher high. This shows that momentum in this advance is weaker than at the previous peak, signalling an unsustainable uptrend. At that point, traders can start thinking about selling to take profit.
Conversely, when price breaks below its previous low and confirms the downtrend, but the RSI does not make a new lower low, momentum in the downtrend has run out and buying pressure may soon return. In this case, divergence is also used to identify a buy point.
The RSI is best used together with a trend indicator such as the moving average, or with some reliable reversal candlestick patterns.
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Happy trading !
