Beginner traders and investors in any market are often confused at first glance at the lines and indicators. In this article, we provide a full guide about one of the most important technical tools called RSI indicator with simple words for beginners and advanced.
What is the RSI indicator?
RSI is the abbreviated form of the Relative Strength Index. This indicator was developed by J. Welles Wilder Jr. an American engineer best known for his activities in technical market analysis. The main task of the RSI indicator is to evaluate and inform traders about overbought or oversold conditions in the price of a traded stock or other assets in the market. The RSI indicator is displayed as an oscillator meaning a line graph that moves between 0 and 100. There are many reasons why RSI has become a reliable indicator for traders that we go through them in this article.
How RSI indicator is calculated?
Two basic components used to calculate are the average gain and the average loss. The default period of calculating is 14-period.
Here is how the average gain and the average loss is calculated:
Average Gain = [(previous Average Gain) * 13 + current Gain] / 14.
Average Loss = [(previous Average Loss) *13 + current Loss] / 14.
First Average Gain = Sum of Gains over the past 14 periods / 14.
First Average Loss = Sum of Losses over the past 14 periods / 14.
As you probably have noticed using the prior value and the current value is also used in calculating an exponential moving average.
Finally, the RSI is calculated with the formula below:
RSI= 100 – 100/1 + RS
RS = Average Gain/ Average Loss
Wilder’s formula actually normalizes RS and turns it into an oscillator that fluctuates between zero and 100. As mentioned earlier the look-back period used for calculation is 14 by default however this can be lowered to increase sensitivity or raised to decrease sensitivity based on the trader’s decision and type of analysis.
How to use RSI indicator in trading?
Here is a list of signals that you can get from the RSI indicator in order to interpret them into useful analysis results that lead to accurate decisions in the trading market.
Overbought and oversold detection
When the RSI is at around 70% of its maximum value (ie, above 70), it is in the buying saturation zone. This means that the asset is overbought or overvalued and the price is likely to fall. When the RSI is below 30, the area will show selling saturation. This means that the assets are oversold or undervalued and create a good time to buy.
These numbers are different depending on the trader’s decisions. For example, some traders use a combination of 33 and 66 percent, while some traders use numbers 20 and 80 percent.
Example of overbought and oversold
For example, consider the figure below that shows the price chart of a particular company’s stocks. As you can see, in places marked with vertical lines, we have seen the RSI enter the overbought or oversold areas, which have been a sign of a change in the price trend direction. For example, at a point marked with a red arrow, the value of the RSI has dropped to less than 30%, which means oversold, and after a while, we see a decrease in sales pressure and the stock price growth. on the other hand, points which are marked with green arrows, we can see an increase in RSI to more than 70%, which means overbought, and after a while, we see a decrease in buying pressure and falling prices.
The thing to keep in mind about RSI is that it is possible to exit overbought and oversold areas, without falling or rising in price, and only with price fluctuations. To clarify the issue, if we look again at the price chart above, we see that in the place marked with a red line, the RSI has entered the overbought zone, but after a while there is no falling price, while we have only the price fluctuating. So always keep in mind that using the indicator alone can, in some cases, cause inaccurate decisions and it must be used along with other tools.
RSI Divergences usually indicate a price trend reversal point.
A bullish divergence occurs when the particular asset’s price makes a lower low while the RSI fails to recognize it correctly and forms a higher low. RSI not confirming the lower low shows strengthening momentum. A bearish divergence forms when the particular asset’s price records a higher high and RSI forms a lower high. By the mean RSI does not confirm the new high and this shows weakening momentum.
For example, as you can see in the chart above, there is a bullish divergence between the RSI and the price. The price in this chart has recorded a lower low. For this reason, the trend line obtained from each is in the opposite direction. After a few days, prices have risen and divergence has been confirmed. Divergence can also be used to find a possible point of sale in upward markets.
However, keep in mind that divergences are not always a great signal for selling or buying in the marker. In some cases, divergences are misleading in a strong trend. It is possible that a strong uptrend shows many bearish divergences before reaching an actual top. Conversely, bullish divergences can appear several times in a strong downtrend and the trend continues to fall.
RSI Failure Swings
Failure swings are also assumed as a great signal of an impending reversal. Failure swings focus on RSI for signals, while they ignore the concept of divergences. A bullish failure swing happens once RSI moves below 30, which is a sign of oversold in the market as mentioned earlier, then pulls back and breaks its prior high. By the mean it reaches to oversold levels and then gets to a higher level above oversold area.
On the other hand a bearish failure swing happens once RSI moves above 70, pulls back, and then breaks its prior low. Basically it moves to overbought levels and then gets to a lower high beneath those levels.
RSI Centerline crossovers
Many investors and traders use the Relative Strength Index indicator with collecting signals from centerline crossovers. Since RSI moves between 0 to 100 you can set 50 as the centerline. A movement from above the centerline, that assumed to be 50, to below shows the market price trend is falling. By the mean falling centerline crossover occurs when the indicator’s value crosses the 50 centerlines below and moves towards the 30 lines. This is a bearish signal until the RSI gets close to the 30 lines.
On the other hand movement from below the centerline, that assumed to be 50 to above shows the market price trend is rising. By the mean rising centerline crossover happens as soon as the indicator’s value crosses above the 50 centerline and moves towards the 70 lines. This is a bullish signal until the RSI gets close to the 70 lines.
Keep in mind that in case you are expecting a possible uptrend in market prices you need to check if the RSI is above 50 and similarly in case you are looking for a downtrend in market prices check if the indicator’s value is below 50. This is how RSI gives traders the chance to confirm trend formations when they think any trend is forming in the market.
Support and resistance analysis with RSI
By connecting the minimum RSI points to each other, you can reach the dynamic support, and by connecting the maximum points to each other, you can reach the resident level. The higher the RSI support and resistance levels are, the higher their credibility would be and more reliable they can be in trades.
According to experienced traders the best settings for the RSI indicator is 14 period with overbought level as 60 (or traditionally 70) and oversold level as 40 ((or traditionally 30) with the aim of trend identification in markets. However, the best settings for identifying trend reversal is 14 period with overbought as 70 and oversold level as 30.
Like most of the indicators used in technical analysis, RSI signals are more reliable when they are used in long-term trends. However, you can rarely determine the true reversal signals are since they may be difficult to separate from false alarms. As you definitely know none of the technical indicators can predict while they can do is to indicate. RSI just similar to other indicators cannot predict with certainty when a trader should enter a trade or when he should exit. This indicator should not be used only for signals but should be used alongside analysis charts. The stock market conditions cannot be determined using this indicator. By the mean RSI alone is not a completely reliable indicator and should not be used in making trade decisions on its own. Indicators are only a follower of the trend and a tool to help technical analysis, and you can never use a single indicator to go to the buying and selling position. It is appropriate to obtain confirmation of them with the help of technical analysis tools.