What is the RSI indicator?
RSI stands for Relative Strength Index, and it has become one of the most popular technical indicators in the trading of stocks and Forex (Foreign Exchange).
Developed by J. Willes Wilder, and published in his 1978 book named New Concepts in Trading Systems, the RSI helps investors detect when prices are potentially overbought or oversold. It is a momentum oscillator, and can be used in trading any equity on financial markets.
The indicator measures both velocity and magnitude of directional price movements. Two parameters can be adjusted. The number of periods, and the level of the RSI itself. The standard settings for the indicator is 14 periods, overbought level to 70, and oversold level to 30.
Common use cases
Although the indicator is mostly used in non-trending markets, also referred to as range-bound markets, the RSI indicator can also successfully be applied when prices are trending. However, the indicator should not be used in the same manner in the above mentioned scenarios. (see below)
In investment theory, price is a result of the relationship between buyers, also known as bulls, and sellers, commonly referred to as bears.
When the bulls are stronger, and prices go up, it is expected that a retracement will take place at a certain time. When the RSI is in overbought territory, investors consider closing their buy positons. Conversely, when the indicator shows oversold, traders seek to open new buy trades, or close any open sell positions.
General guidelines for using the indicator
The indicator is most commonly used by swing traders. Swing traders recognize that price action is cyclical in nature, and features predictable and frequently occuring retracements. In the absence of trend, swing traders buy assets in oversold areas, and sell them in overbought areas.
If the indicator is set to a standard configuration of 14 periods, overbought at 70, and oversold at 30, traders will act below 30, and above 70. When trading Forex, swing traders open buy positions below 30, and sell positions above 70.
Although the indicator gives an indication of future direction, is is not particulary good for timing entries. Because of this, trades often use the RSI together with candle analysis. In the Forex market, investors known as scalpers, often wait for a strong move downward, to immediately open a buy trade and vice versa. They count on an instant pullback, after which they close their position with profit.
Alternatively, you can wait for price to move out of overbought or oversold, before taking action. This is important, especially if the market is trending strongly.
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The RSI consists of two parameters. Number of periods and the RSI level itself. The higher or lower the level, the more extreme the overbought and oversold signals become, and the fewer trades you will make.
You can also adjust the sensitivity of the RSI, by simply reducing the number of periods e.g. when periods are set to 7, the indicator looks back only 7 previous candles, not the standard 14. For seeing how the RSI is calculated, click here.
Using the RSI in range-bound markets
In range bound markets, the indicator is in a league of its own. When trading the forex market, essentially you open buy trades when oversold, and sell trades when overbought.
You can choose to wait for confirmation, or be aggressive and trade when as soon as a candle opens in overbought or oversold areas. If you are trading stocks, you go long when the asset is oversold, and go short when overbought.
Look for clearly identifiable support and resistance levels, when determining whether the market is range bound or trending.
Making use of the RSI in trending markets
Master traders know that in trending markets, you have to tread carefully with the RSI. When markets trend up, you can observe higher highs, and higher lows. Conversely, when markets trend downward, you will observe lower highs and lower lows.
It is therefore important to note, that in an upward trend, taking a sell trade in overbought territory is risky, as the trend might continue. This applies to oversold as well. (see chart below)
The correct way of applying the indicator in trending markets, is to take buy trades on pullbacks, but only when prices are trending up. (See chart below)
Take sell trades when pullbacks happen, but only when prices are trending downwards. (see chart below)
Faling to follow these guidelines can lead to disaster.
The relative Strength Index (RSI) is an extremely powerful indicator, and is on a very short list in the company of MACD, Moving Average, Directional Movement System and a few others.
Some investors have gone so far as to say that the only indicator they need, is the RSI. In clearly range bound markets, characterized by support and resistance levels, you can trade the indicator comfortably, and be quite profitable.
In trending markets, you should trade only the pullbacks, and always in the direction of the trend.