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.
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.
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.
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.
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:
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.
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.