RSI (Relative Strength Index) is a technical analysis tool that shows the speed and amplitude of asset price movement. In fact, it reflects the strength of the trend and helps predict its reversal.
A bit of history
RSI’s author is American mechanical engineer John Wells Wilder, Jr. The index first appeared in Commodities magazine in 1978. Wilder spoke in more detail about RSI and other technical analysis indicators (ADX, SAR, ATR) in his book The New Concepts of Technical Trading Systems.
Wilder is a self made trader and analyst. Being an expert in the field of exact sciences and a real estate developer, in the early 70s he decided to trade stocks. Even though it didn't immediately become a major success, several years of active research paid off.
The indicators developed by Wilder combine mathematical formulas and his personal trading experience. This combination makes them invariably relevant for traders and analysts in the traditional and cryptocurrency markets for more than fifty years.
How RSI works
How to calculate RSI
The main task of the RSI indicator is to show the change in the asset price over a certain period of time. It requires two equations to make calculations.
1. First you need to determine RS - the initial value of the relative strength:
RS = Average Upward Closing Price (UP) over time / Average Downward Closing Price (DOWN) over time
2. Then you can move on to the actual value of RSI, which, as a result of calculations, is a value from 0 to 100:
RSI = 100 - 100 / (1 + RS)
For what time periods can RSI be determined?
Traditionally, the index is determined for 14 time periods. Depending on the characteristics of the charts, it may be 14 hours, 14 days, etc.
In addition to the classic version, traders can implement individual settings by reducing or increasing the time period. For example, for intraday trading, the optimal solution would be N from 9 to 11.
For long-term traders, it is better to choose a longer period, which allows you to increase the sensitivity of the indicator. Its duration is from 20 to 30 days.
The Relative Strength Index not only shows the dynamics of the asset price, but also helps to detect overbought and oversold conditions. How to correctly interpret the obtained indicators?
When working with RSI, you need to pay attention to the signal levels 0, 30, 50, 70 and 100:
- the 30-70 interval is the central zone. An indicator of more than 50 indicates an increasing investor interest in the asset and a price increase. A value less than 50 indicates that traders are predominantly trying to sell the asset rather than buy it. This leads to lower prices;
- the interval from 70 and above is the overbought asset. In this state, its value exceeds market expectations;
- the interval from 30 and below is the oversold asset. This situation is accompanied by a significant drop in prices, which exceeds the traders’ forecasts.
Please note that depending on the duration of the period, the key signal values may change. Meaning that for intraday trading, levels 20 and 80 are considered more sensitive. Signals 35 and 65 also belong to frequently used pairs.
How to use RSI
With the help of RSI, you can determine the right time to make a trade:
- at values greater than 70, the probability of an early price collapse increases against the backdrop of an overbought market. Having caught a trend reversal, traders place deals to sell;
- with an index less than 30, one should expect an upcoming price increase. In this case, you can prepare for buying deals.
An easier way to work with RSI is to trade from level 50. By choosing this option, you need to watch the curve level breakdown direction. Moving up - open with a buy, down - open a sell position.
Bullish and bearish divergences
Divergence is a feature that is common for all oscillating indicators. In this state, the cost direction and the RSI indicator do not coincide. Divergence should be viewed as an early warning of a trend reversal, helping to develop a suitable strategy for the near future.
Is the asset value falling and making low minimums, but the RSI reading shows an upward direction and hits higher minimums? This is called a bullish divergence. It warns of an increase in buying interest and a possible fast trend change to an uptrend.
The hallmark of a bearish divergence is an increase in the asset value, hitting higher maximums when the RSI value decreases and lower maximums are formed. It reflects the fading of market momentum, which may be followed by a change in trend to a downtrend.
The RSI indicator allows you to successfully determine the moments for entering and exiting a position. Analyze the trend’s state and the market as a whole. It will be most effective in combination with other technical analysis tools. Using them will help you successfully deal with false signals and develop effective trading plans.