Tue. Oct 20th, 2020
RSI Intellinvestors

How To Use The Relative Strength Index — Master The Applications Of The Popular Oscillator

If you follow technical analysts who post some of their charts on Twitter, you've probably seen them use the RSI or the relative strength index to aide their analysis. The RSI's simplicity makes it a favorite for technical traders, but what is its purpose anyway? Signal a trade? Determine the strength of a trend? Well, in this post, you'll be able to find the answer to that, and after reading, hopefully, you'll also learn how to use the relative strength index yourself.

What is RSI?


RSI is one of the indicators that was developed by J. Welles Wilder Jr., and it's displayed on the charts as a graph with values of zero to one hundred. The calculation makes use of the average gains and losses divided over a certain period (14 days was Wilder's suggestion).

The calculation and the steps will be discussed in a different post.

What's the purpose of RSI?


RSI has different purposes, and listed below are six of its most common uses:

1. Identifying the strength of a trend


The most common way traders use the RSI is to determine the strength of a trend, and they do this by referring to the 30 and 70 levels on the RSI graph.

If the RSI shows a reading of 30, that is interpreted as the asset in an oversold condition, and there might be room for buyers to enter and reverse things around by sparking some buying activity.

On the flip side, when a reading shows 70, then an asset could be overbought, marking a convenient time for sellers to take over and drive prices down.

2. Determining the general direction of price


The 50 level of the RSI is also significant as it tells the general direction of price. When RSI reads above the midpoint, the price is usually trending upwards. If it's below 50, the price is trading lower.

RSI midpoint

The chart above is a good example of how the midpoint serves as a technical trader. For illustration purposes, the 50 moving average is also drawn on the chart to show how the oscillator's midpoint functions similar to the indicator.

3. Signaling a Trade


Most traders don't use RSI to signal a trade, and some even advise against it. But for those who do, the same levels 30 and 70 are used as the entry and exit points.

And, using the interpretation of overbought and oversold conditions at those two extreme levels, some traders take positions that coincide with the likely direction of price based on the RSI reading.

RSI overbought and oversold

For example, if RSI reads 70 (overbought) and the price is trading upward, traders would take a sell position in hopes of seeing it move in the opposite direction.

Conversely, if RSI is 30 (oversold), then traders who use this strategy take a buy position.

One thing to note is that 30 and 70 are not inflexible. You can choose to tweak those levels in your charting package to provide you signals that are more apt to the market or asset you're trading.

4. Supplementing analysis


Another way traders use RSI is to supplement their analysis. Traders employ different indicators in their charts, and not all of them serve the same purpose.

Moving average, for instance, isn't typically used for determining overbought and oversold levels: it can serve many purposes, and one is dynamic support and resistance areas.

In supplementing other technical tools, traders use RSI as a gauge or a way to confirm their trade entry.

Take the chart below, for example. The RSI crossed below 70, and the EUR/USD fell back after hitting the area marked by the horizontal line on 1.3288. Some traders will use these two sell signals to short the EUR/USD and perhaps target the ascending trendline below.

RSI crossing below 70

5. Spotting Momentum Change


Another way the RSI works is to spot a possible change in the direction of the price. This is often called divergence, and it occurs when the RSI moves in a different direction that the asset being traded.

Look at the chart below.

RSI divergence

You'll see that the chart above is the same chart used in the previous example, but with the addition of two trendlines drawn on the RSI graph and the EUR/USD price.

Notice how the trendline on the RSI chart is sloping downwards, and the trendline on the price is slanting upwards. This is an example of divergence.

What divergence tells a trader is that momentum could be changing and that a reversal in the direction of the price may be imminent.

In this example, the RSI was on point, as it did precede a rally that went on for two months.

6. Signaling a Failure Swing


In Charles D. Kirkpatrick II and Julie A. Dahlquist's second edition of their Technical Analysis: The Complete Resource for Financial Market Technicians book, they note that RSI can also signal a failure swing.

A failure swing happens when RSI crosses above 30 or crosses below 70, reverses, and takes an aim back to the overbought or oversold area, then misses and proceeds to the direction of the correction.

Here's an example:

Technical Analysis: The Complete Resource for Financial Market Technicians (2nd Edition)
RSI failure swing

The RSI crossed the overbought region and was heading up (remember that this may indicate a signal for buyers to come in), but just when it was about to get higher, it reversed course and tried to dip under 30 once more.

However, the attempt to exceed the overbought area failed, and the RSI ticked higher.

You could also say that this happened twice in succession as the RSI reached a higher value after its initial failure swing.

Summary


Using the RSI is a great addition to other technical tools: It helps you determine the strength of a trend, reversal, failure swings, and its midpoint level also indicates the general direction of price. And, in some cases, traders also use RSI to signal a trade.

Trade using the RSI yourself

Have you tried backtesting technical indicators to find out how effective they are?

If you haven't, click on the link below and find out what backtesting is and how it will help you in your trading.

9 thoughts on “How To Use The Relative Strength Index — Master The Applications Of The Popular Oscillator

  1. Thanks for telling us how to use the relative strength index as it is something that traders must know if they want to be successful. I have also heard something of bar methods and candlestick formations that can tell when a stock is going to change or surge up and you can make hundreds/thousands in an hour if you are good at it. Have you tried bar method/candlestick formations?

    1. Hi Jon,

      Thanks for commenting!

      Well, the purpose of this is to teach people that there’s a whole study behind analyzing price action. This RSI indicator is based on calculations of past prices, and the ones we mentioned here are what they tell traders. As far as the candlestick formations, yes, we know about them, and we utilize them in some of our analyses, but we need to remember it’s important for us to remember that the whole point of this is to make an educated guess as to where the price is likely heading.

  2. Hello, I must say that this article is very helpful and informative. I am glad I stumbled upon your article because I wanted to learn about RSI indicator, I trade binary options and I usually use RSI indicator to predict the trend, now I see that I don’t know much about it, thank you for sharing such useful tips and advice.

  3. Hi

    I can see how the relative strength index can be used as an indicator of how well a company is doing. It is effectual as it is a visual way of showing how well it is going, and us humans seem to respond better if we can visual see it. Often when we are exposed to rows of numbers we often get bored but with charts we can make decisions very we quickly. You can really get a lot as described in this excellent article. As with everything it will have limitations as it cannot reveal everything and this can mislead people. I always say it pays off to be cautious but I got to admit they look very impressive and simple to use, which makes them a useful tool.

    Thanks

    Antonio

  4. The topic of Forex trading is specialized and for the astute investors. There are many beginners that would like to try Forex trading and the post about how to use, interpret and apply RSI I am sure it is welcomed.

    You have a well developed website covering multiple investment markets: gold, bonds, forex and stocks and the training provided is always appreciated by beginners.

    Nice, comprehensive website and RSI indicator post.

  5. Wow! Thank you for sharing this post explaining RSI and how we can use it to our own advantage in our business The relative strength index (RSI) for me is an amazing indicator that is capable of improving our profits if properly mastered considering its six purposes. I appreciate J. Welles Wilder Jr. for such an amazing development.

Leave a Reply

Your email address will not be published. Required fields are marked *