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RSI trading strategy explained
The Relative Strength Index (RSI) is a momentum indicator used in technical analysis. It measures the speed and extent of a security’s recent price fluctuations to accurately identify overbought or oversold conditions within its price.
The RSI is visually represented as an oscillator—a line graph—scaled from zero to 100. It was developed by J. Welles Wilder, Jr. and introduced in his foundational 1978 publication, “New Concepts in Technical Trading Systems.”
In addition to identifying overbought and oversold conditions in securities, the RSI can also highlight securities poised for a trend reversal or corrective price pullback. It also provides signals of potential buying and selling opportunities. Typically, an RSI reading of 70 or above indicates overbought conditions, while a reading of 30 or below indicates oversold conditions.
The RSI is one of the most widely used technical indicators and is commonly integrated into most trading platforms offered by online stock brokers.
How RSI strategy works?
The Relative Strength Index (RSI), a momentum indicator, compares a stock’s strength during upward price movements to its strength during downward price movements. Relating this comparison to price action enables traders to understand a stock’s potential performance.
The RSI, especially when used in conjunction with other technical indicators, significantly enhances traders’ ability to make well-informed trading decisions.
calculating RSI
Calculating the Relative Strength Index (RSI)
The calculation of the Relative Strength Index (RSI) consists of two steps, beginning with the following formula:
The “average gain” and “average loss” represent the average percentage gain and loss over a specified time period.
A positive value is used for the average loss.
Periods of declining prices are treated as zero when calculating the “average gain.”
Periods of rising prices are treated as zero when calculating the “average loss.”
The standard lookback period for calculating the initial RSI is 14 periods.
Example:
Let’s assume that the market closed higher on seven of the past 14 days, with an initial average gain of 1%.
The remaining seven days closed lower, with an initial average loss of -0.8%.
The first RSI is calculated as follows:
After 14 periods of data are available, a second calculation is performed to reconcile the results. This ensures that the RSI only approaches 100 or zero during strong market trends.
Plotting RSI
After its calculation, the Relative Strength Index (RSI) is typically plotted below the asset’s price chart. The RSI rises as the frequency and magnitude of upward price movements increases, and decreases as the frequency and magnitude of downward price movements increase.
It is important to note that the RSI may remain in the overbought zone for extended periods during an asset’s uptrend.
Similarly, it may remain in the oversold region for extended periods during a downtrend. This behavior can be confusing for novice analysts. However, understanding how to interpret the indicator in the context of the prevailing trend will resolve these confusions.
Why RSI Important?
The Relative Strength Index (RSI) is important for several key reasons:
- Predicting price Behaviour: Traders use the RSI to anticipate security price movements.
- Verifying trends and reversals: Helps traders confirm existing trends and identify potential trend reversals.
- Identifying overbought and oversold conditions: The RSI highlights when a security is overbought or oversold.
- Issuing buy and sell signals: Provides short-term traders with actionable buy and sell signals.
- Supporting trading strategies: As a technical indicator, it can be effectively combined with other indicators to enhance trading strategies.
How To Use RSI With Trends?
Modify RSI Levels to Fit Trends
Understanding the underlying trend of a security is crucial to accurately interpreting Relative Strength Index (RSI) readings. For example, renowned market expert Constance Brown (CMT) suggests that during an uptrend, an oversold RSI reading is likely significantly higher than 30. Similarly, an overbought reading during a downtrend is typically much lower than 70.
During a downtrend, the RSI often peaks near 50 rather than 70. Traders can consider this a more reliable indicator of bearish conditions.
To better distinguish the overall trend and identify extremes, many investors draw a horizontal trend line between 30 and 70 when a strong trend is emerging.
Conversely, adjusting the RSI levels for overbought or oversold conditions is usually unnecessary when a stock or asset’s price is within a long-term horizontal channel or trading range, as opposed to a strong uptrend or downtrend.
The RSI shows less reliability in trending markets than in trading ranges. In fact, many traders admit that RSI signals in strong uptrends or downtrends are often false.
Use Buy and Sell Signals That Fit Trends
A related concept focuses on trading signals and techniques that align with the prevailing trend. Specifically, using primarily bullish signals during an uptrend and primarily bearish signals during a downtrend can help traders mitigate false signals that the RSI may produce in trending markets.
What Is a Bullish RSI Number?
The definition of bullish RSI levels varies depending on market conditions, specifically whether the market is trending up, down, or trading within a range.
One recognized bullish signal occurs when the RSI drops below 30, indicating an oversold condition. However, it’s important to remember that bullish RSI signals are most effective in uptrends. In a clear downtrend, the trend may continue even after momentum indicators reach oversold levels. Furthermore, trades initiated based on this signal may yield limited profit potential, as they will be counter to a strong, recent trend.
Conversely, during a strong uptrend, a bullish RSI signal is generated by a reversal after a decline to around 40-50. This area is typically considered a support zone during an uptrend. This reversal often confirms a positive shift in momentum toward the prevailing uptrend after a pullback, indicating the possibility of a continued upward movement.
What Is a Bearish RSI Number?
Bearish RSI signals mirror bullish signals, but they operate in the opposite direction. A primary bearish signal occurs when the RSI crosses the 70 level, indicating an overbought condition. If this is followed by a decline below the 70 level, this indicates a potential decline in upward momentum, alerting traders to a potential price reversal.
However, it is important to note that bearish RSI signals are most effective when applied within established downtrends.
During a strong downtrend, a primary bearish RSI signal is a trend reversal after a rise to the 50-60 range. This often serves as confirmation of a return of downward momentum after a pullback, indicating a potential further decline in prices.
The Difference Between RSI and MACD
The Moving Average Convergence Divergence (MACD) indicator is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The result of this calculation is the MACD line.
A signal line of the nine-period MACD average, known as the signal line, is then plotted above the MACD line. This signal line can serve as a trigger for buy and sell signals. Traders can initiate a buy trade when the MACD crosses above its signal line, and sell or short the security when the MACD crosses below it.
The Relative Strength Index (RSI) is designed to indicate whether a security is overbought or oversold relative to recent price levels. It is calculated using the average of price gains and losses over a specified time period. The default time period is 14 periods, with values ranging from 0 to 100.
The MACD measures the relationship between two exponential moving averages (EMAs), while the Relative Strength Index (RSI) measures the momentum of price change relative to recent highs and lows. These two indicators are frequently used to provide analysts with a comprehensive technical overview of the market.
Both indicators measure the momentum of an asset. However, they measure different factors and can sometimes give conflicting signals. For example, the RSI may show a reading above 70 for an extended period, indicating that a security is overbought. At the same time, the MACD may indicate that buying momentum for the security is still increasing. Either indicator may signal an imminent trend reversal by showing divergence from the price (the price continues to rise while the indicator declines, or vice versa).
Limitations of the RSI
The Relative Strength Index (RSI) compares bullish and bearish price momentum and displays the results as an oscillator positioned below the price chart. As with most technical indicators, its signals are most reliable when they align with the prevailing long-term trend.
True reversal signals are rare and can be difficult to distinguish from false signals. For example, a false positive signal occurs when a bullish crossover is followed by a sudden drop in a stock’s price. Conversely, a false negative signal occurs when a bearish crossover is observed, yet the stock experiences a sudden rise.
Because the indicator measures momentum, it may remain in overbought or oversold areas for extended periods when the asset shows significant momentum in either direction. Therefore, the RSI proves effective in an oscillating market, also known as a trading range, where the asset’s price alternates between bullish and bearish movements.
