Relative Strength Index (RSI)

The Relative Strength Index, or RSI, was created by Welles Wilder, and its main purpose is to identify extreme conditions in the market. By showing if the market is in oversold or overbought territory, we can make better trading decisions.

The RSI is an oscillator that is scaled from 0 to 100, with readings below 30 indicating oversold, while readings over 70 indicate overbought territory.

Using the RSI in Trading

The RSI can be used to identify extremes, to confirm a trend and also to identify divergence. We will look at each of these principles in detail.

1. To Identify Extremes

One main use of the RSI is to identify market extremes.
Oversold Territory

If the RSI is below 30, this is the oversold territory. Selling pressure is high and a technical correction is likely. Prices are forming a bottom since there are no more sellers and therefore buyers begin to come into the market. Prices eventually head back up.

If the RSI indicator turns up as well, then this is a good opportunity to buy.

Remember that just because the RSI falls below 30, it does not mean it is a signal for immediate buying because the RSI may stay in the oversold territory for a long time. In order to enter at the right moment (on true market reversal) you should wait for the RSI to leave the oversold territory.

Look at the chart below. When the RSI goes below 30, you would be on the lookout for an opportunity to buy, however your actual trade will take place only when the RSI crosses up above 30.

Overbought TerritoryIf the RSI is above 70, this is overbought territory. Buying pressure is high, and prices will form a top. Fewer buyers remain in the market and sellers begin to come in. A correction is likely, turning prices back down. If the RSI turns down as well, this is a good opportunity to sell.

Note Before Trading:Once the RSI goes above 70, you should wait for the indicator to come out of the overbought area and cross below 70 before placing your sell order. Look at the chart below.

2. To Confirm a Trend

The RSI indicator can be used to confirm the trend of the market.One way to do this is to draw trend lines on the RSI indicator. If the RSI’s trend line stays intact, it confirms that a trend holds well. RSI trend lines are especially useful on larger time frames. Look at the chart below.
With the RSI trend lines you are able to receive a much earlier warning about upcoming trend changes since RSI trend lines will often warn of a breakout a few candles earlier than chart trend lines. Some technical analysts like to use the 50 level of the RSI for additional confirmation of a trend. If we see prices are in an uptrend on the chart, we can confirm this trend by looking at the RSI. If the RSI crosses above the 50 level from below, the uptrend is confirmed. On the other hand, if prices are in a downtrend on the chart and the RSI breaks below the 50 mark from above, we can confirm the downtrend. Referring to the chart below, we insert a 50 line in the RSI indicator section (see the red line).

3) To Identify Divergence

Another way to use the RSI indicator to help us trade better is to identify RSI divergence signals. What is divergence? Sometimes the RSI indicator will not move in the same direction as the market. This is what is called divergence. It is useful for informing us of an impending trend reversal and giving us the opportunity to enter a trade. We can identify bullish and bearish divergence.

Bullish divergence occurs when the market is in a downtrend and prices are making a new low but the RSI does not continue lower and instead begins to climb back up. This is a bullish signal indicating that the trend is about to change direction to an uptrend. This gives us the opportunity to buy.

Bearish divergence occurs when the market is in an uptrend and prices are making new highs but the RSI does not continue higher. Instead the RSI turns down. This is a bearish signal indicating that the trend is about to change direction and become a downtrend. This gives us the opportunity to sell.

Useful Hints

When the RSI approaches 30 from below watch for a bullish divergence => slowly rising RSI versus already declining prices. When the RSI approaches 70 from above you should look for a bearish divergence, which occurs when actual RSI readings begin to decline while prices are still climbing.

Summary

Divergence suggests that a current momentum is over. Therefore you should protect any current profits and be ready to trade in the opposite direction.

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