What is RSI: You might see that many traders and investors use the RSI indicator on their chart for technical analysis. You might feel that this very difficult approach.
But that is not true. In this article, we are going to discuss this in a very simple and easy manner.
RSI is a well-known Leading indicator of the stock market. It is used extensively by most famous traders and even investment analysts.
RSI serves as a very good tool for both intraday traders, swing traders, long-term investors, scalpers, and even option traders. Therefore knowing such a widely used tool is highly important and beneficial as well. In this article, we will cover both traditional and advanced methods of using RSI and trading with RSI. Without wasting our time we will move towards our main topic.
Table of Contents
What is the RSI indicator?
The full form of RSI is the Relative Strength Index.
Meaning of RSI
As the name suggests it indicates the strength of stock prices relative to itself.
e.g. When we say RSI 14, the 14 is look back period. The indicator compares the average up closing and down closing for the last 14 candles or closing (depending on the time frame we are working upon).
RSI formula =100-[100/(1+RS)]
RS= Average of net up closing/Average of net down closing
As far as trading, investment, and portfolio management is concerned, knowing what is RSI and how RSI is generated is sufficient.
More about RSI
RSI is a leading indicator because it compares the price of the previous closing and indicates possible upcoming outcomes.
Cautious Note on RSI
Since it is a leading momentum indicator; please do not use it directly to find the trend, volume, breadth, volatility, and sentiment of a stock. The application of RSI is very wide and has to be interpreted properly and cautiously.
How to use RSI indicator?
1. How to read RSI
Being an oscillator RSI fluctuates between 0-100. 0 being highly bearish and 100 is highly bullish. 0-100 are extreme values that RSI can show. For general-purpose, RSI approaching towards 70/80 or above 70/80 is a sign of bullishness, and RSI approaching towards 30/20 or below 30/20 is a sign of bearishness.
2. The price action of RSI
If net prices tend to close up I.e. higher than the previous one RSI will rise and similarly if net prices tend to close below the previous one RSI will fall. Indicating bullishness or bearishness respectively in particular chart prices.
3. What does the RSI level mean?
1. RSI level 70/RSI level 80
Typically these levels are considered overbought.
Interpretation:- Prices are relatively high. Stock can show price-wise or time-wise correction.
Action:- Can take partial profit or be cautious about your position.
Precaution:- Being overbought does not mean you should short-sell. Short sell only when there is a clear signal of shorting.
2. RSI level 30/RSI level 20
Typically this level is considered oversold.
Interpretation:- prices may be relatively low. Stock can show price-wise or time-wise correction.
Action:- If already short cover some position I.e. book profit.
Precaution:- being oversold doesn’t mean you should buy. Get long only when there is a clear buy signal on a strategy that you are following.
Best suitable period for RSI
Generally, we have seen, by default software run on RSI 14. This means it compares the closing price of the last 14 days/hours/minutes or whatsoever time frame we are using for trading.
If we select period 3/4/5, we could get a very volatile signal. If we use 30/40. Then it will be a very long period and the trading signal will be less relevant.
Showing overbought and oversold regions is the primary function of RSI.
But additional to it RSI can even give you a buy and sell signal.
RSI can also be used to determine whether the trend is valid or particular support and resistance are valid.
What is divergence in RSI?
As we see when the price moves upward RSI value rises and when the price falls RSI value fall. So following the pattern we should ideally get that when price makes higher high RSI should also make higher high and when prize makes lower low Prices should make a lower low.
But, the trick comes here and important price action can be seen. Whenever price action and RSI does not match with each other we called it divergence i.e. divergence from price action or price behavior.
Since RSI is a leading indicator most of the time prices will follow RSI in interpretation. But always be careful price action is Supreme and indicator are just there to get a high probability trading setup
RSI chart reading
If you are using RSI as the main indicator then read the RSI line chart the same way you read the price chart.
Things to look at on the RSI chart
Mark support and resistance lines on RSI with comparison to price action. Generally, if the trend is upward then the RSI support trend line will have a positive slope and similarly, if there is a downward trend then the RSI resistance trend line will have a negative slope.
If you are a swing trader or pullback trader with entry-level primarily focusing on retracement then use a similar retracement level with an RSI chart to validate your entry or trade.
As discussed in the above part, divergence in RSI is one of the most significant phenomena you could observe while interpreting the RSI chart.
There are basically 4 types of RSI divergence which we will discuss
A) Simple bearish divergence – It appears in a downtrend.
Prices make lower low and RSI makes a higher low.
Indicating trend is likely to reverse or halt.
B) Hidden Bullish Divergence -In uptrend.
Prices make higher low but RSI make a lower low.
Indicating the trend is strong and likely to continue further.
C) Simple bullish divergence – In uptrend.
Prices make higher high but RSI makes lower high.
Indicating trend is likely to reverse or halt.
D) Hidden Bearish Divergence:-
Prices make lower high but RSI make higher high.
Indicating a strong downtrend and trend is likely to continue further.
While reading RSI and divergences use a line chart for both RSI and price action on a closing basis.
Divergence should be regular and not intermediate.
1. Another way of interpreting RSI chart is looking for patterns in it. E.g. flag, triangle, Cup and handle, double top, double bottom, triple top, triple bottom, roundedtop, rounded bottom, rectangle, Pennant, head and shoulder, raising wedge, falling wedge and many other.
2. Combine RSI divergence with a Fibonacci retracement to use it as a strategy.
3. RSI divergence can also be combined with your existing trading Strategy to filter the signal and get in depth movement of price action.
Remember everyone’s trading style and risk capacity is different. So before selecting your trading time frame keep your risk capacity in the account.
Properly and effectively combining RSI with your strategy for building a strategy completely based on RSI is possible only through backtesting, forward testing, and live practice. Finally, knowing and applying RSI incorrect way will definitely give you an edge in interpreting price action. Hope you understand “What is RSI?”
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Happy Investing and Trading !