How to Use the RSI Indicator?
The Relative Strength Index is a momentum oscillator used in technical analysis to measure the magnitude and velocity of price movements over a specific period. The RSI helps traders identify overbought or oversold market conditions and predict trend reversals or support and resistance levels through bullish and bearish divergences.
Traders often rely on technical analysis (TA) to anticipate future trends and price movements in various markets, including traditional and cryptocurrency markets. One of the tools utilized in TA is the Relative Strength Index (RSI), which was developed in the late 1970s.
The RSI is a momentum oscillator that measures the magnitude and velocity of price movements over a specific period. It's an excellent tool for traders with varying profiles and trading setups. J. Welles Wilder created the RSI indicator in 1978 as part of his book, New Concepts in Technical Trading Systems. The book contains several other TA indicators such as the Average True Range (ATR), Parabolic SAR, and Average Directional Index (ADX).
Wilder began his career as a mechanical engineer and real estate developer before transitioning into trading stocks in 1972. Initially, Wilder experienced limited success in trading. However, he compiled his trading experience and research into mathematical formulas and indicators. The book was written within six months and has since become a vital reference for chartists and traders globally, despite being authored in the 1970s.
How Does the RSI Indicator Work?
The RSI is a technical trading tool that measures the changes in an asset's price over a specific period. The default period used by the RSI is 14 periods, which varies depending on the chart used. For daily charts, the period is 14 days, while for hourly charts, it is 14 hours.
The formula used to calculate the RSI plots data on a scale ranging from 0 to 100. It calculates the average gain the price has had over the set period divided by the average loss it has sustained.
Traders use the RSI to measure the magnitude and velocity of price movements over a specific period. The indicator is used to evaluate the rate at which the price or data is changing. When the price is rising, and momentum increases, it indicates that the stock is being actively bought in the market. Conversely, if momentum increases to the downside, it is a sign that the selling pressure is increasing.
- Traders use the RSI as an oscillating indicator to identify overbought or oversold market conditions more easily. The RSI evaluates the asset price on a scale from 0 to 100, considering 14 periods.
- An RSI score of 30 or lower implies that the asset is likely near its bottom (oversold), while a score above 70 suggests that the asset price is probably near its high (overbought) for that period.
- Traders can adjust the RSI to increase or decrease its sensitivity, with the default settings being 14 periods. For instance, a 7-day RSI is more sensitive to price movements than one considering 21 days.
- In short-term trading setups, the RSI indicator can be adjusted to consider 20 and 80 as oversold and overbought levels (instead of 30 and 70), making it less likely to produce false signals.
Using RSI to Predict Trend Reversals and Identify Divergences
The RSI is often used by traders to determine overbought and oversold market conditions, as an RSI score of 30 or less may suggest that an asset is oversold, while a score above 70 may indicate that it is overbought. Traders also use the RSI to predict trend reversals or to identify support and resistance levels through bullish and bearish divergences.
Bullish divergence happens when the RSI score rises while the price falls, indicating that buying force is strengthening despite the price downtrend. Bearish divergence, on the other hand, suggests that the market is losing momentum despite the price rise, as the RSI score drops while the asset price increases.
Keep in mind that RSI divergences are not always reliable, especially during strong market trends. In volatile markets with significant movements, bearish and bullish divergences can happen multiple times before an actual bottom or top is reached. Consequently, RSI divergences are more useful in less volatile markets that feature subtle trends or sideways movements.
To avoid false signals, traders should keep in mind that no technical indicator is 100% efficient - especially when used alone. Therefore, it is important to use the Relative Strength Index (RSI) indicator along with other indicators. When using the RSI indicator, there are several important factors to consider, including the settings, the score (30 and 70), and the bullish/bearish divergences.