What Is the RSI Indicator? How to Use RSI Most Effectively

Combining a set of technical indicators – an oscillator (such as the Stochastic, Momentum or RSI) with a trend indicator such as a moving average (MA) – is the usual approach to 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 best-performing indicators for swing traders.

What is the RSI indicator?

The RSI (Relative Strength Index) is a momentum indicator widely used in technical analysis to measure the strength of price. The RSI was developed in 1978 by J. Welles Wilder.

Like many other indicators, the RSI uses price as its basic input – specifically, the price data of the previous X sessions (candles). The most common value of X is 14 sessions – RSI(14) – the default set by Wilder himself.

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 that the current trend is balanced.
• The <30 and >70 zones are considered the indicator’s oversold/overbought thresholds, where buying or selling pressure overwhelms the other side.

How the RSI works

As a momentum indicator, the RSI compares the strength of a stock or commodity on up days with its strength on down days. The RSI provides confirmation when the current price trend moves in step with the RSI’s own direction. That is why the RSI, used alongside other technical indicators, can help traders make better-informed decisions.

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.

Using the RSI to confirm the trend

The RSI confirms an uptrend when:

• The RSI crosses above 50 from below.
• The RSI trends up in step with price.

The RSI confirms a downtrend when:

• The RSI crosses below 50 from above.
• The RSI trends down in step with price.

Using the RSI to identify overbought and oversold levels

A high RSI reflects strong buying pressure and a low RSI signals strong selling pressure. 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, a stock whose RSI enters oversold territory 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 (back above 30). The best sell points come when the RSI falls and confirms its exit from overbought territory (back below 70). 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.

Bearish RSI divergence

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. That is a sign of bearish (negative) RSI divergence. At that point, traders can start thinking about preparing a sell order.

Bullish RSI divergence

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. That is a sign of bullish (positive) RSI divergence, also called convergence. In this case, divergence is also used to identify a buy point.

Failure Swings

This is a very useful technique from Wilder himself: when the RSI enters overbought or oversold territory, he regarded failure swings as a strong sign of an impending reversal. Failure swings are independent of price action; they focus only on the RSI for signals and ignore the concept of divergence.

A bullish failure swing has four stages:

1. The RSI drops into oversold territory (RSI < 30).
2. The RSI rises back above 30.
3. The RSI pulls back but does not return to oversold territory.
4. The RSI rises and breaks above its most recent high.

As you can see in the chart above, the RSI dropped into oversold territory (1), then rose back above the 30 oversold level (2), pulled back without returning to oversold (3), and then rallied strongly to break the high it had just made (4).

Similarly, a bearish failure swing has four stages:

1. The RSI rises into overbought territory (RSI > 70).
2. The RSI falls back below 70.
3. The RSI bounces but does not climb back into overbought territory.
4. The RSI then falls and breaks below its most recent low.

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Happy trading !