- June 22, 2021
- Posted by: CoachShane
- Category: Trading Article
The Relative Strength Index by J. Welles Wilder is one of the most popular technical indicators being used.
The RSI compares the strength of up days to the strength of down days and with that calculation, we can determine if the momentum taking place is either bullish or bearish (consider lack of momentum as well).
It then plots at value between 0 and 100 making it a bounded indicator.
The most common settings that traders tend to watch are:
- 80/20 where 80 is an overbought level and 20 is an oversold level
- 70/30 where 70 is overbought and 30 is oversold
Traders that blindly take make trading decision at those levels or treat them as trading signals, tend to lose money over time. While these levels can show you the strength of the market, you need other techniques to trade off of them.
Relative Strength Index Formula
1978 saw an article published in Commodities Magazine by Welles Wilder where the Relative Strength Index was introduced to the public. It was followed up in a book by Wilder called New Concepts In Technical Trading Systems.
The RSI oscillates using a calculation that compares the relative strength of gains in price of days that close above previous days close (up days) to the price loss on days that close below previous days close (down days).
RSI Calculation = (100 – (100 / (1 + U/D))
To aid in that calculation, Wilder suggested a look back period indicator setting of 14 periods be used.
If you do decide to tweak the default settings of the Relative Strength Index, try to line up RSI turning points at the 80/20 or 70/30 lines with the turns in the market.
A longer look back will ease off on the volatility of the RSI where a shorter look back will see more volatility in the indicator.
How To Trade With RSI
The oversold overbought settings are a common approach to the RSI. The issue is that markets can stay in those conditions for a long time.
If you were using overbought to exit a long trade expecting a reversal or looking to short, you’d be stepping off some serious gains in Bitcoin.
The RSI is no different than most indicators: trade them blindly and you will miss out on good moves and also rack up losses.
What are some ways to use RSI if oversold/overbought is not that great?
RSI Divergence + Oversold and Overbought
This was the first introduction to the RSI back in 1978. Quite simply, we are looking for the indicator to diverge from price.
- If the market is in an uptrend, we are comparing highs in price to the highs in the RSI
- If in a downtrend, we compare the lows
Using this approach, we need the RSI to be either oversold or overbought and then show us divergence.
This stock is in an overall uptrend and you can see points on the chart where the RSI makes lower highs in the overbought zone (+70).
Price is making higher highs but the lower high in the RSI coupled with being overbought, gives us a clue that there may be a reversal due to a bearish divergence.
This is a perfect example of divergence using the RSI. There are times where you will get divergence but price does not react the way the textbooks suggest. It is important to have supporting variables to your trading and that is where knowledge of structure and price action will serve you very well.
How would you enter this trade?
You don’t want to jump into a short without some type of confirmation especially in an uptrend.
Traders can set an order to sell below the candle that makes the higher high and the RSI makes a lower high.
In this example, one trade does not trigger by breaking the low of the candle. The other one gaps down taking out the low. You could enter when the breakout from the range occurs, failure test of highs, or any number of other methods.
Another technique would be to drop down to a lower time frame chart for entry such as a 15 minute chart.
This is the first setup from the original chart that gave a small gain. When using the 15 minute chart, you have a large move that you take advantage of that fills the gap.
RSI Support and Resistance
Traders will also use the RSI as a means to find support and resistance levels that may not be evident on the trading chart.
There is no difference with how you draw your lines as you would do it the same way as the price chart. Either horizontal lines are used as well as using a trend line by itself or to help form a trend channel.
Using this chart, refer to the arrows on the RSI and follow up to the price. The one I find the most interesting is the highest peak and where the RSI showed potential resistance at that point. I much prefer using this RSI technique with channels as shown on the right side.
While this technique may have merit, my preference would be to refer to price for support and resistance as opposed to a derivative of price calculation.
2 Period RSI
This is from Larry Connors and by the setting, you know the RSI will be a more volatile momentum indicator. This is what you want with this trading approach.
We will use the setting of 2 period and take our oversold and overbought levels to 95 and 5. Connors does suggest using a moving average for trend indication but price action is a good option as well.
This is a chart of Bitcoin and the cryptocurrency is clearly in a shorter term downtrend as it makes lower highs and lower lows.
Once price hits +95 we are looking to short as the market is overbought in the short term and this is a bearish signal.
You need an entry trigger and this example uses a trendline break entry method.
This example shows the trade entry when a candle closes red below the 5 period EMA.
You can also use candlestick patterns such as the 3 bar reversal to enter your trades.
This is AMC daily stock and price movement shows us in a trading range. We’d be looking for bullish signals at the bottom of the range and bearish at the top.
The range plays did well and depending on your exit strategy, you may have been in before that strong trend run in price.
For example, on the second bullish signal entry, price hits resistance but does not fall back into the small range.
This highlights the importance of having not only stop loss exits, but also how you manage and take profits in your trades.
Without a trading plan, you are flying blind.
RSI Trading FAQS
The relative strength index is quite the versatile technical trading indicator and the simplicity and apparent robustness can be intriguing for further testing if you found interest.
Perhaps there is merit to slightly optimizing so the OS/OB of the indicator lines us with recent swings in the market. This would probably be something you’d want to do on the higher time frame charts (daily, weekly) as intra-day has many more swings to contend with.
What Does the RSI Tell You?
The RSI will show you the momentum of the market and when price is potentially oversold/overbought and primed for a reversal. The swing levels on the RSI will point out potential divergence trades
What is Bearish Divergence?
Price makes a higher high and the RSI makes a lower swing high. This is more powerful when it takes place while the RSI is overbought.
What is Bullish Divergence?
Price makes a lower low while the RSI makes a higher low. Taking place in the oversold zone makes it a better setup.
How to use the RSI for day trading?
Using the 2 period RSI setting is a good use of this indicator for day traders.