Financial markets are a complex and volatile environment, where investors and traders are always looking to find the best instruments.
And strategies to achieve success and profits. One of these important tools in the world of trading is the RSI technical indicator, which is widely used by professional and novice traders alike to analyze price movements and make trading decisions.
In this article, we will explore this popular indicator in detail, from explaining its basics to the most popular RSI trading strategies. We will also provide some practical tips and real-world examples to help you understand how to use it effectively and get the most out of its different settings.
RSI Concept
The Relative Strength Index (RSI) is one of the most popular technical indicators used in the trading world. It was designed by engineer and technical analyst J. Welles Wilder in 1978. This indicator measures the speed of change in the price movements of a financial asset (such as a currency, stock, or commodity), providing insight into the strength of the current trend and potential reversal points.
The RSI formula measures the ratio of gains to losses over a specified period of time, usually 14 days, and is scored on a scale from 0 to 100.
The basic principle behind using the RSI indicator is Wilder's belief that prices move in short-term and long-term cycles. Knowing when the market price has overbought or oversold helps identify potential reversal levels and then seize trading opportunities.
How to Read RSI Indicator Signals
There are four signals that can be read from the RSI, which are:
Buying saturation and selling saturation
The basic reading that traders get from the RSI indicator is the overbought and oversold levels in the market price.
Overbought and oversold are two terms used in technical analysis to describe market conditions where an asset is believed to be trading at a quantity above its true value (in the case of overbought) or below its true value (in the case of oversold).
These two terms are often used with momentum indicators such as the Relative Strength Index (RSI), where:
Overbought: Refers to a market condition where prices are believed to have risen excessively high and may be about to correct or decline. In the RSI indicator, this condition is usually identified above the 70 level.
Oversold: Refers to a market condition where prices are believed to have fallen excessively, and may be about to recover or rise. In the RSI indicator, this condition is usually identified below the 30 level.
Divergence:
Divergence, the term commonly used in English, is divergence in momentum indicators in general, to which the RSI indicator belongs, such as the Stochastic indicator and the MACD indicator. It indicates the difference between the price trend and the trend of the momentum indicator line.
If the price is moving in a certain direction (up or down), while the momentum indicator is moving in the opposite direction, this indicates a divergence signal. This divergence can be positive or negative:
Bullish Divergence:
It occurs when the price is falling (downtrend), and at the same time the momentum indicator is rising. This indicates that there is a slowdown in the downtrend, and there may be a possibility of a reversal to an uptrend soon.
Bearish Divergence:
It occurs when the price is rising (uptrend), and at the same time the momentum indicator is falling. This indicates that there is a slowdown in the upward trend, and there may be a possibility of a reversal to the downside soon.
Divergence in momentum indicators can be a strong signal for traders to predict reversals or changes in price direction.
Determine the direction by cutting the center line:
The RSI indicator can also be used to determine the strength of the current trend. When the RSI line rises above the 50 center line, it is a signal that the price is moving in an upward direction. When the RSI line falls below the 50 center line, it is a signal that the price is moving in a downward direction.
It is important to remember that although the RSI can provide valuable signals, it should always be used in conjunction with other analytical tools to ensure the validity of these signals and reduce the risk of false signals.
Advanced RSI Indicator Settings
When we look at the RSI indicator, we find that it comes with default settings that are widely used. Of course, you can modify these settings to suit your own trading style or to increase the accuracy of the indicator signals.
Here are the settings:
Period: The period setting usually expresses the number of time periods being analyzed. The default period setting for the RSI indicator is 14, but it can be adjusted according to your needs. If you prefer short-term analysis, you can reduce the period to 7, while you can increase it to 21 or more if you prefer long-term analysis.
Overbought and Oversold Levels: The default values for the overbought and oversold levels of the RSI are 70 and 30 respectively. You can adjust them according to your strategy and the assets you are trading. For example, if you are trading assets with stable prices and low volatility, it is recommended to lower the overbought level to 40 or 60 to get more signals.
Other Indicators: You can also combine other indicators with the RSI to improve performance. For example, using the Simple Moving Average (SMA) or Stochastic with the RSI can provide more accurate trading signals.
Using these custom settings you can improve the performance of the RSI indicator and make it a powerful tool for making better trading decisions.
Beyond Levels 30/70
Although the 30 and 70 levels on the RSI are common levels for identifying overbought and oversold conditions, they may not be sufficient or ideal in all market scenarios. How RSI signals are interpreted is greatly affected by different markets and changing economic conditions, requiring a more flexible and in-depth approach to using this indicator.
As we mentioned earlier, in low volatility markets using less extreme levels such as 40 and 60 on the RSI can provide a different approach that focuses on identifying market conditions that are not yet overbought or oversold, but may indicate the beginning of a change in momentum or confirmation of the current market trend.
Using the 40 and 60 levels can also help confirm the continuation of the trend. For example, when the market is in an uptrend, an RSI above 40 and above 60 can be considered an indication that the uptrend is strongly continuing. Likewise, when the market is in a downtrend, an RSI below 60 and above 40 can be considered an indication that the downtrend is strongly continuing.
80% confidence level
Some traders use more extreme levels such as 20 and 80. These levels are more conservative and may reduce the number of false signals in a highly volatile market, making it more likely to capture market shifts more reliably.
Adjusting the overbought and oversold levels of the Relative Strength Index (RSI) to 20 and 80 instead of the standard 30 and 70 can provide advantages in some cases and is used for specific trading purposes. Here are some of the benefits and use cases of these modified levels:
Reduce false signals:
In highly volatile markets, raising the threshold for overbought and oversold peaks and adjusting the RSI level to 20 and 80 may reduce the number of false signals. By making the criteria more stringent for identifying extreme conditions, the indicator becomes more conservative and reduces the likelihood of reacting to normal price movements or market noise.
Focus on big moves:
Using the 20 and 80 levels helps to focus on large and important price moves, which means that traders can take action based on stronger and clearer signals regarding buying or selling peaks.
Long term trading strategies:
For traders who rely on long-term strategies and target large trend changes, the 20 and 80 levels can provide safer entry points and limit the risk of entering too early or too late.
Identify strong buying or selling opportunities:
When the RSI indicator reaches below 20 or above 80, it may indicate strong buying or selling opportunities respectively, as the markets have reached extreme oversold or extreme overbought.
RSI Indicator Strategies Used by Experts and Must Be Mastered
Best RSI Indicator Strategies
The Relative Strength Index (RSI) is a powerful tool that can be used with a variety of strategies to capture the strongest trading opportunities in the financial markets. There are many trading strategies that use the RSI indicator, either alone or in combination with other indicators and technical tools.
Here are some of the most prominent strategies used by professional traders and market experts:
Divergence Strategy:
This strategy is based on identifying the occurrence of divergence between market prices and the RSI indicator.
When a positive divergence forms, where the RSI is rising while market prices are falling, it may indicate a potential trend reversal to the upside, and this can be considered a buy signal.
Conversely, when a negative divergence forms, where the RSI is declining while market prices are rising, it may indicate a potential trend reversal to the downside, and this can be considered a sell signal.
Breakout Strategy:
This strategy is based on breaking overbought or oversold levels (such as 70 and 30).
When the RSI breaks the 70 level from top to bottom, it may be a sell signal.
When the RSI breaks the 30 level from bottom to top, it may be a buy signal.
Overbought/Oversold Reversal Strategy:
This strategy uses overbought and oversold levels (such as 70 and 30) to identify trading opportunities when the RSI crosses them.
When the RSI crosses the 70 level and falls back below it, it may be a sell signal.
When the RSI crosses the 30 level and rises back above it, it may be a buy signal.
Support and Resistance Strategy:
This strategy is based on support and resistance levels in the market, as well as the RSI indicator.
When the RSI indicator crosses the 70 level and the price approaches a resistance level, it may be a sell signal.
When the RSI indicator crosses the 30 level and the price approaches a support level, it may be a buy signal.
These strategies can also be combined with other technical analysis tools such as Japanese candlesticks and support and resistance levels to enhance the analysis. Professionals sometimes neglect to use multiple indicators to verify signals and arrive at a more accurate analysis.
In the following article we will explain the most important strategies used for the RSI indicator.