In trading we try to find ways to gain an edge in the market. A technical analyst has varies ways and tools in his toolbox to do so. The use of indicators does not give us a 100% accuracy in predicting future price movements, but can help traders to easily identify high-probability trading setups.
One of the more universally accepted indicators is the RSI, or in full the Relative Strength Index. The RSI is a momentum oscillators, that measures the speed and change of price movements.
In this article, we’ll discuss what the RSI exactly is, and how we can use it to get an edge in the market, considering three trading methods.
In the field of techinical indicators there is a broad array of different types. All of them measure something else. The RSI, developed by Welles Wilder, is a momentum oscillator that can be used for many different purposes like signaling extreme price movement, trend analysis and divergence in price. Being a oscillator means that its values ranges between 0 and 100, and measure the speed and change of price movements.
The RSI is generally plotted with lines at the 30 and 70 mark. These lines indicate whether a market can be considered ‘overbought’ or ‘oversold’. Sometimes traders use 20-80 levels instead. Using 20-80 levels will increase accuracy but lowers the amount of trading setups.
When the RSI line is below 30, the market is condisered “oversold”, indicating that it is likely ready for a move up. Vice versa is the case when the RSI line is over 70, than the market is considered “overbought”, indicating it is ready for a move down.
The RSI equation is build up from an input variable the RS, and the main equation transforming its values into a range variable.
The RS variable measures the strength of price movements on up-candles versus the strength on down-candles, for a selected interval. A regular time interval would be 14 or 20. A high RS indicates that price movement on up-candles has been much more powerful than it has been on down-days. The higher the RS-value, the higher the RSI.
By just looking at the equation a question could be what to do if for the time interval selected there where no down-days. In these circumstances we would have to devide by 0, so therefore the RS-value would be 0. The answer is ‘no’, in such cases the “average loss” will then be set really low, so we get a RS-value that is larger than 0. This is not uncommon using short timeframe RSI settings. The RSI will fluctuate a lot more and with it, likely generate many ‘overbought’ and ‘oversold’ signals.
The RSI follows the market; if the market goes up, the RSI will go up as well. Same if the market goes doen, the RSI will go down too. Like with price movements, we can also draw trendlines on the RSI. The trendline of the market and RSI should be pointing in the same direction. If the RSI breaks certain trendlines while the market keeps his original movement, it signals that we have to be cautious. A divergence between RSI and market are clear warning signals for a potential direction change.
Now let’s see how the use of the RSI can help us in our trading strategies. We will check three different trading methods all purely based on the RSI. These are: crosses of overbought/oversold levels, catching reversals and price divergence, and using multiple timeframes as filter.
Method #1: Cross overbought/oversold levels
This method is the most common and easiest approach to trade using the RSI oscillator. This simple way of trading the RSI can also be one of the more effective. The trading approach is simple: go short when the RSI crosses the ‘overbought’ level (70) downwards. A signal for taking a long position happens when the RSI crosses the ‘oversold’ level (30) upwards.
RSI crossovers are counter-trend entries looking for near-term retracements. If these retracements turn into full reversal, the potential return can be large.
Method #2: RSI Divergence
Instead of the traditional way of looking for overbought and oversold levels in trading the RSI, traders can also look for divergences. Since the RSI is an oscillator it can be used to identify divergences that can help us spot potential market reversals. A divergence occurs when the market moves in a different direction as the RSI-indicator.
A Bullish divergence on the RSI occurs when the market is still moving down, while the slope of the RSI is moving upwards. Indicating that the market is ready for a potential upward reversal. A Bearish Divergence occurs when the market is moving up, while the RSI slope is downwards. Which indicates that the market is ready for a reversal to the downside.
It is important to realize that indicators can stay overbought or oversold for long periods of time. Even you are trading this strategy, you are taking counter-trend positions. It is therefore very important to use proper risk management, since a trade can be extremely costly if the trend does not reverse.
Method #3: Using the RSI with multiple timeframes
Another method gaining an edge in the market using the RSI. Is by using it to assimilate price action from varying points of view. The longer timeframe charts give us information of what the general trend direction is. Using this information in confluence with your short term trading decisions should improves accuracy. Examples of timeframe combinations are: The daily with the weekly, the hourly with the 4-hour chart, etc.