The Relative Strength Index (RSI) is one of the most popular technical indicators used by stock, forex, and cryptocurrency traders. This comprehensive guide will teach you everything you need to know about the RSI indicator – how it works, what it indicates, strategies to trade with it, and much more.
What is the Relative Strength Index (RSI)?
The Relative Strength Index is a momentum oscillator developed in 1978 by technician J. Welles Wilder Jr. The RSI measures the speed and rate of price changes to analyze overbought or oversold conditions in an asset.
The indicator has become a staple technical analysis tool used by traders of all markets. The RSI oscillates between 0 and 100 – a reading above 70 indicates an overbought asset while a reading below 30 signals an oversold asset.
How the RSI Formula Works
The Relative Strength Index calculation is based on the average gains and losses over a fixed lookback period. The standard RSI setting is 14 periods.
Here is the RSI formula:
RSI = 100 – (100 / (1 + RS))
RS = Average Gain over last 14 periods / Average Loss over last 14 periods
Gain = The total positive price movement over 14 periods
Loss = The total negative price movement over 14 periods
The RSI measures the ratio of gains against losses over the specified lookback period. Strong uptrends lead to higher average gains than losses, so the RS ratio climbs above 1. This causes the RSI to move above 50.
During downtrends, losses outpace gains so the RS ratio falls below 1. This pushes the RSI below 50.
Why the Default 14 Period Setting?
The default 14 period setting for the RSI was determined by Wilder through extensive backtesting. He found it struck the optimal balance for responsiveness and smoothing.
Shorter RSI lengths like 7 or 9 are more responsive but also more volatile. Longer lengths like 21 or 25 are smoother but have more lag.
Most traders stick to the standard 14 RSI length as it captures short-term swings while filtering out daily market noise. But the RSI period can be adjusted based on your trading style and time frame.
Overbought vs Oversold RSI Readings
The Relative Strength Index has natural upper and lower limits at 100 and 0. Wilder identified RSI levels above 70 as overbought and levels below 30 as oversold.
When the RSI nears or exceeds 70, it signals the asset’s price has risen too far too fast. This identifies bullish exuberance and overheating that could foreshadow a trend reversal.
Conversely, an RSI below 30 indicates panic selling has pushed the price too low too quickly. Oversold signals anticipate a potential trend change higher.
However, overbought and oversold levels do not automatically trigger reversals. The RSI can remain overextended for long periods during strong trends. Use 70/30 as warning zones rather than outright signals.
How to Use RSI for Trading
The Relative Strength Index has many applications for trading. Strategies using the RSI include:
- Identifying overbought/oversold levels
- Spotting divergences
- Trading RSI pullbacks
- Using RSI for additional confirmation
- Determining strength of the trend
- Identifying potential reversals
Next we will explore how to utilize the RSI indicator for trading in detail.
Trading Overbought and Oversold Levels
The classic way to trade RSI is to look for overbought and oversold readings near 70 and 30 as signs of impending reversals.
For example, if a stock has been in a strong uptrend, the RSI steadily climbing above 70 warns of overheating. Traders will watch for bullish price momentum to slow and for a pullback or reversal lower.
The opposite applies to an oversold RSI below 30. With the RSI deeply oversold, traders eye an upcoming surge higher and trend change.
However, markets can remain irrational longer than you can remain solvent. Just because the RSI hits 70 or 30 doesn’t guarantee an immediate reversal. Use overbought/oversold signals as alerts for potential trade opportunities. Wait for confirming price action before entering.
Identifying RSI Divergences
The RSI is also useful for spotting divergences from price. A divergence occurs when the indicator and price are moving in opposite directions.
For example, if the stock is making new highs but the RSI is failing to exceed its prior highs, it signals potential bearish divergence. This warns that upside momentum is waning.
Conversely, if the stock is making new lows but the RSI holds above prior lows, it signals bullish divergence. This hints upside momentum is building.
Traders look to trade RSI divergences in the direction of the anticipated breakout. Divergences often lead to major trend changes.
Trading RSI Pullbacks
Oversold RSI levels near 30 present buying opportunities. You can look to enter long pullbacks when the RSI nears or dips into oversold territory.
For example, when a stock is in a strong uptrend, use oversold readings to help time entries for buying the dip. Take long positions with a stop under the recent swing low.
The opposite applies for taking short positions when the RSI exceeds 70. Oversold RSI levels allow you to time entries to sell short into counter trend bounces.
Using overbought/oversold zones to trade RSI pullbacks combines the indicator’s best features. You get smoother whipsaws from the trending zones along with timely entry signals.
Using RSI for Confirmation
The RSI is also helpful for confirming price action trading signals. For breakouts, only trade in the direction the RSI leans for added confirmation.
If the stock breaks above resistance, check that the RSI is above 50 and pointing higher before buying. For breakdowns below support, make sure the RSI is under 50 and falling.
Think of the RSI as providing evidence for your trading signals. Only trade breakouts if the momentum agrees with the price action. The RSI improves your timing and probability of success.
Determining Strength of the Trend
Analyzing the RSI trend and pattern provides clues on the strength and staying power of price moves.
For example, if the RSI is above 50 and rising with the uptrend, it signals strong underlying momentum. But if the RSI starts carving lower highs, it’s a caution flag of waning momentum even if price continues higher.
Also watch how the RSI acts at overbought and oversold turns. If the RSI makes a higher low at 30, it signals bullish momentum. But a lower high near 70 indicates a weakening uptrend.
Identifying Potential Reversals
In addition to overbought and oversold levels, the RSI often forms reversal chart patterns that foreshadow price turns.
For example, a double top or lower high pattern on the RSI can mark major market tops. A double bottom or higher low can signal an upcoming bottom.
The RSI will also form bullish and bearish reversals (RSI failure swings) near overbought and oversold zones:
- Bullish reversals occur when RSI crosses below 70, moves below the prior low, then crosses back above 70.
- Bearish reversals are when RSI crosses above 30, rallies above the prior high, then drops back below 30.
Reversal signals indicate the RSI is losing momentum in its trending direction and is primed to snap back the other way.
Tips and Tricks for Trading RSI
Keep these tips in mind to apply the RSI indicator successfully:
- Adjust the RSI length and overbought/oversold levels based on the market and time frame. Faster markets require shorter RSI settings.
- Use 70/30 as warning zones, not automatic signals. Wait for confirmations like divergences or chart patterns.
- Focus on trading RSI reversals and failures at extreme highs and lows. These signal imminent trend changes.
- Look for RSI confirmation on price action signals like support/resistance breaks for higher probability trades.
- Combine RSI with other indicators like moving averages for more robust signals. Use the RSI to add momentum context.
- Don’t initiate new trades when the RSI is near the 30 or 70 limits. Look for re-entries as it returns to equilibrium.
- Analyze both the RSI direction and pattern. This gives insight into market strength and momentum.
With the right techniques, the RSI can significantly improve your timing on entries, exits and trade management. Mastering this oscillator will make you a better trader.
Common RSI Trading Strategies
Now let’s discuss some actionable RSI trading strategies you can implement right away:
RSI Overbought/Oversold Bounce
This straightforward approach sells overbought strength and buys oversold weakness.
Rules for RSI Overbought/Oversold Bounce:
- Enter short when RSI exceeds 70 by trading the tight range or break below pivot low
- Place stop above recent swing high
- Book profit when RSI reaches 50 or below 30. Trail stop lower.
- Enter long when RSI drops under 30 by trading the tight range or break above pivot high
- Place stop below recent swing low
- Book profit when RSI climbs to 50 or above 70. Trail stop higher.
This method trades mean reversion at extremes. Use shorter time frames for timing entries and exits.
RSI Divergence Trade
Divergences signal a mismatch between RSI and price that anticipates trend reversals.
Rules for Trading RSI Divergences:
- Identify bullish divergence when price makes lower low and RSI makes higher low
- Enter long on break above entry trigger like resistance or 20-period MA
- Place stop below local swing low
- Target initial resistance level. Trail stop to lock profits
- Spot bearish divergence when price makes higher high and RSI makes lower high
- Enter short on break below entry trigger like support or 20-period MA
- Place stop above nearby swing high
- Target initial support zone. Trail stop to protect capital
Use larger time frames like daily or 4-hour to spot reliable RSI divergences.
RSI Two Periods, Two Levels
This strategy combines overbought/oversold zones with RSI direction for a higher probability system.
Rules for RSI Two Periods, Two Levels:
- Only go long if the RSI is under 50, then rallies above 50 and has surge above 70
- Enter bullish trades on pullback after RSI crossover breakout above 50
- Place stop under recent swing low or below 50 RSI
- Book partial profits at the RSI’s overbought level 70 and exit remainder at 90/10 level
- Only go short if the RSI is over 50, then drops below 50 and falls under 30
- Enter bearish trades on bounce lower after RSI crossover breakdown under 50
- Place stop above nearest swing high or above 50 RSI
- Take partial profits at the RSI’s oversold level 30 and close remainder at 10/90 level
Adding RSI direction filters and two exit points improves results. This combines oscillator mechanics with momentum techniques.
Bollinger Bands + RSI Strategy
Combine Bollinger Bands with RSI for even stronger trade signals.
Rules for Trading BB and RSI:
- Buy when price bottoms near the lower BB band and RSI nears 30
- Place stop below lower band
- Book profits at the moving average or upper band
- Look to short when price peaks near the upper BB band and RSI approaches 70
- Set stop above upper band
- Close short at the moving average or lower band
This strategy provides clear entries, stop loss levels, and profit targets using two friendly indicators.
How to Add the RSI Indicator on Charts
The RSI is standard on most trading platforms like MetaTrader 4, TradingView, ThinkorSwim, MT5, NinjaTrader, and more.
If the RSI is not shown, follow these steps to add it:
- Open the Indicators list
- Search for and select the Relative Strength Index
- Drag the RSI onto the price chart
- Adjust inputs (e.g. periods, levels) as desired
The indicator will now display along the chart based on your preferred settings and analysis can begin!
Most traders start with the default 14 period RSI with 70/30 overbought/oversold levels. Adjust these parameters to better suit your trading approach and market.
RSI vs. Other Indicators
The RSI has some similarities and differences when compared to other major indicators:
RSI vs. Stochastics – Both are bound momentum oscillators. Stochastics tends to be more sensitive with more signals. RSI is smoother with fewer whipsaws.
RSI vs. MACD – MACD is a trend following momentum indicator. RSI is range bound but better for identifying divergences.
RSI vs. CCI – CCI focuses solely on market extremes. RSI incorporates overbought/oversold signals along with trend analysis.
RSI vs. Momentum – Momentum measures pure price velocity while RSI incorporates relative strength. RSI filters signals better and is less jumpy.
- RSI helps cut down false signals vs. stochastics and CCI
- RSI incorporates trend directionality lacking in oscillators like momentum
- RSI more useful identifying divergences than trend focused MACD
RSI Limitations and Disadvantages
While a valuable indicator, the RSI has some drawbacks to be aware of. Here are the main weaknesses and pitfalls traders should know:
- Lagging indicator – Since the RSI is based on prior prices, it is always lagging current price action. RSI signals will fire after the initial move occurs.
- Range bound – The RSI oscillator fluctuates between its 0-100 range. It does not reflect absolute momentum or trend strength.
- False signals – Divergences don’t always play out. Markets can stay overbought or oversold for extended periods. Use confirmations.
- Choppy markets – The RSI tends to whip back and forth during trading ranges giving many false signals. Less useful in sideways trends.
- Parameter dependence – altering the RSI period or overbought/oversold levels can significantly impact results and signals.
While not perfect, the RSI remains an invaluable indicator when applied properly. Combine with additional analysis and use proper risk management on trades.
RSI Best Practices and Tips
Follow these tips to maximize success using the Relative Strength Index:
- Use longer time frames for analysing overbought/oversold levels and divergences. Daily and 4-hour charts are ideal.
- On shorter time frames, use 10 and 20-period RSI settings for faster yet smooth analysis.
- Play reversals off 30/70 only on longer time frame signals, not short term extremes.
- Focus on RSI direction – uptrends want to see RSI above 50 and vice versa.
- Trade with the major trend. Use pullbacks at extremes for lower risk entries in the main direction.
- Beware of divergence fakeouts. Only trade confirmed divergences on heavy volume with clear support or resistance.
- For less whipsaws, only trade at overbought/oversold turns above 80/below 20 or with RSI swing failures.
Following sound RSI trading guidelines boosts your overall accuracy and profitability.
RSI Trading System Rules
Here are the complete rules for a swing trading system using the RSI:
Go Long (buy) if:
- Price closes above the 20 period EMA and RSI is above 50
- Entry on retracement to 20 period EMA with RSI above 50 and turning up
- Place stop loss below recent swing low
Go Short (sell) if:
- Price closes below the 20 period EMA and RSI is below 50
- Entry on bounce back to 20 period EMA with RSI below 50 and turning down
- Place stop loss above recent swing high
Exit long positions if:
- RSI drops below 40 signaling loss of upside momentum
- Price closes below 20 EMA indicating trend change
- Protect profits with trailing stop below 20 EMA
Exit short positions if:
- RSI rises above 60 signaling loss of downside momentum
- Price closes above 20 EMA showing uptrend resuming
- Protect capital with trailing stop above 20 EMA
Following a structured RSI system provides objective entry, exit and stop loss rules for disciplined trading.
Common RSI Trading Mistakes to Avoid
While powerful, the RSI is often misused. Steer clear of these common RSI trading mistakes:
- Trading overbought/oversold bounces without confirmation – Markets can drift in overextended zones leading to false signals. Wait for additional signs like failures or divergences before acting.
- Initiating trades when RSI is near extremes – New positions taken as the RSI exceeds 70 or nears 30 are prone to immediate reversals. Look for re-entries as RSI returns to equilibrium zones.
- Over-optimizing RSI parameters – Don’t relentlessly curve fit RSI periods or overbought/oversold levels. Let the market dictate appropriate settings based on testing.
- Forgetting about trend context – Use RSI to trade in the direction of the bigger trend for better odds. RSI oversold in an uptrend = buy, RSI overbought in downtrend = sell.
- Not using stop losses – RSI signals won’t be perfect. Use stops to limit downside, ride trends, and protect trading capital.
- Trading RSI as standalone indicator – For best results combine RSI with price action and other indicators. RSI performs best alongside MACD, stochastics, Bollinger Bands etc.
Avoiding common errors preserves capital and improves your win rate with the RSI oscillator.
Frequently Asked Questions About the
What timeframes is RSI most effective?
The RSI can be used on charts ranging from the 1 minute up to the monthly time frame. Lower timeframes like 5/15 minutes are good for identifying oversold/overbought levels and timing entries. Larger timeframes like 4H, daily and weekly are ideal for analyzing trend strength, spotting divergences, and confirming signals.
What instruments can I use RSI for trading?
The RSI works equally well across forex, stocks, indices, commodities, and cryptocurrencies. As a bound momentum oscillator, it identifies overextensions well on any instrument with chartable prices. The RSI is especially useful on trending markets like forex, commodities, and major stock indices.
Does overbought mean you should sell, oversold means buy?
No, overbought/oversold readings alone are not automatic signal to take trades. It is best to wait for confirmations like failures, breakouts or divergences at extremes before acting. Additionally, overbought in an uptrend is a buy signal, while oversold in a downtrend remains a sell signal.
How do I avoid RSI false signals?
No indicator is perfect, but you can reduce whipsaws by waiting for confirmations, usingFilt combining RSI with other technicals, focusing on reversals at extremes, and honoring the higher timeframe trend context. The most reliable signals come from combining RSI with price action.
Should I only trade when RSI diverges from price?
No, divergence alone is not enough. Look for RSI to diverge as it reaches overbought or oversold extremes for highest probability setups. Additionally wait for a confirmation like the price breaking support/resistance before trading the anticipated move. Quality over quantity with divergences.
What RSI settings are best?
For short term swing trading, faster RSI settings like 8-12 periods work well. For longer term position trading, slower settings like 18-25 periods smooth out oscillations. Most commonly used is the default 14 periods. Unless you have extensive testing and a reason, stick to standard parameters.
Is RSI better than stochastic for day trading?
RSI has advantages in day trading being less choppy, with clearer overbought/oversold zones and better for spotting divergences. Stochastics is more sensitive if using single hour timeframes. For most intraday trading RSI and stochastics yield similar performance – combine both for best results.
Should I avoid trades when RSI is near 30 or 70?
Yes, initiating new longs with RSI near 70 or new shorts near 30 often leads to being stopped out. Look to enter new trades as RSI returns to equilibrium zones between 40-60. You can exception trade small bounces near extremes using tight stops.
Carefully incorporating the RSI into your overall trading plan can significantly improve results. This versatile momentum oscillator works on all timeframes and instruments. Master the RSI and you will make better, more profitable trading decisions.
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