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The Relative Strength Index (RSI) is a widely-used technical analysis tool among traders. Developed by J. Welles Wilder in 1978, the RSI is a momentum indicator that measures the speed and change of price movements. Wilder even wrote a book about it, called “New Concepts in Technical Trading Systems“, which will explain it in more depth.
RSI is known for its depiction of overbought and oversold conditions in the market. These are the two regions traders typically use in their setups.
To understand how it works, we’ll look at its calculation and how it’s often interpreted.
Just like with any major technical indicator, it can be applied with multiple technical analysis tools to bolster your strategy. But also, it comes with its limitations. RSI works well with trending markets, similar to the MACD, and is often used as a reversal signal. Let’s get started.
Understanding the RSI Indicator
The RSI is a momentum oscillator that ranges between 0 and 100. It measures the speed and change of price movements by comparing the size of recent gains to recent losses. A higher value denotes overbought, while the bottom represents oversold.
Calculating the RSI
The RSI indicator has its own calculation, which is done as follows.
First, determine the average gain and average loss over a specified period (typically 14 days). Calculate the Relative Strength (RS) by dividing the average gain by the average loss. Compute the RSI using the formula:
RSI = 100 – [100 / (1 + RS)
Interpreting the RSI
As the RSI oscillates between 0 and 100, traders check whether it’s approaching either of the extremes during a trend. The values can be changed, but the default settings are 30 for oversold, and 70 for overbought.
The general interpretation is that these are the regions where price is starting to get ahead of itself, and needs to come back.
Trading Strategies Using RSI
Here are some popular trading strategies involving the RSI:
Basic Overbought/Oversold Signals
Traders can use the RSI to identify potential entry and exit points by monitoring overbought and oversold conditions. For instance, when the RSI falls below 30, traders may consider buying, expecting a price reversal. Conversely, when the RSI rises above 70, traders may consider selling, anticipating a price correction.
Divergence
Divergence occurs when the price of an asset and the RSI move in opposite directions, signaling a potential trend reversal. A bullish divergence happens when the price forms lower lows, while the RSI forms higher lows. A bearish divergence occurs when the price forms higher highs, while the RSI forms lower highs.
Trendline Breaks
Traders can draw trendlines on the RSI chart, connecting consecutive highs or lows. When the RSI breaks through the trendline, it can signal a trend reversal or a shift in momentum.
Swing Failure
A swing failure occurs when the RSI fails to surpass a previous high during an uptrend or a previous low during a downtrend. This can indicate a potential trend reversal or weakening momentum, providing a trading opportunity.
Limitations of the RSI and How to Overcome Them
Like any technical indicator, the RSI has its limitations. Here are some common issues.
Lagging Indicator
As expected with any momentum indicator calculating the last X bars to plot its points, the RSI is a lagging indicator. It’s used to react to price changes rather than predict them. As a result, it may provide delayed signals, causing traders to enter or exit positions late and potentially miss out on profitable opportunities.
False Signals
The RSI can generate false signals, especially in volatile or range-bound markets. If your strategy is based on finding an entry and exit based on the RSI level, don’t simply enter in that kind of market. It may quickly turn back around on the RSI, while price has not moved much, and these whipsaw trades can add up quickly.
Overbought and Oversold Misinterpretations
Some traders mistakenly assume that an overbought or oversold reading on the RSI always signals an imminent price reversal. However, in strong trending markets, the RSI can remain in overbought or oversold territory for an extended period, leading traders to exit positions prematurely or enter counter-trend trades with poor results.
Not As Effective in Sideways Markets
The RSI is most effective in trending markets, but its signals can be less reliable in sideways or range-bound markets. In these conditions, overbought and oversold levels may not necessarily indicate trend reversals, leading to potential trading losses.
What tends to happen in slower markets is that price moves much less in either direction, but the RSI continues to progress on its curves. Eventually, it crosses the upper or lower level, and a trader may think the market is about to turn and go on a trend. But this is not always the case.
Parameter Settings
The default RSI setting of a 14-day period may not be suitable for all traders or market conditions. You will have to spend some time tampering with it and seeing how it suits your trading style. This limits any sort of consistency or reliable indication of success when starting.
However, this is to be expected, and not really a major limitation.
Conclusion
RSI remains one of the most popular indicators used by technical traders today. It’s something I experimented with before ultimately working with the MACD, and found some minor success doing.
However, as with all indicators, be sure to give it plenty of time and practice in different market conditions. Don’t build a strategy that says “sell when overbought, buy when oversold” or something similar.
In time, you will find that it helps you pinpoint more precise entries and exits along established trends, getting you one step closer to being a master trader.
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