Relative Strength Index is one of the most popular indicators used by traders. It provides information on the strength of price movements on charts, hence its name. So what is an RSI indicator? How to use it in trade? How to understand what he is showing?
RSI indicator: description
Created by J. Wells Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and variation of price movements. The index fluctuates between zero and 100. Traditionally, according to Wilder, RSI shows the overbought market when its value exceeds 70, and oversold when it is below 30. The RSI indicator signals can warn about a trend reversal, the intersection of the center line, and also determine the strength of the trend.
Wilder wrote about all this in his 1978 book, New Concepts in Technical Trading Systems. Together with the parabolic SAR, volatility index, span index and CSI index, he described the RSI indicator - how to use it and how to calculate it. In particular, the author considered the following factors:
- highs and lows;
- figures of technical analysis;
- failed scope;
- support and resistance;
- divergence.
Although Wilder's indicators will soon turn 40 years old, they have stood the test of time and remain extremely popular to this day.
Payment
The indicator is calculated by the formula: RSI = 100 - 100 / (1 + RS), where RS = average growth / average drop.
To simplify the calculation, the index is divided into the main components: RS, average growth and depreciation. In his book, Wilder suggested calculating the index based on 14 time intervals. Fall is expressed by positive, not negative numbers.
First, average growth and average fall over 14 periods are calculated.
- average growth = amount of growth over the past 14 periods / 14;
- average fall = sum of falls over the past 14 periods / 14.
Then, the calculations are based on previous averages and the current fall or growth:
- average growth = previous average growth x 13 + current growth / 14;
- average fall = previous average fall x 13 + current fall / 14.
This method of calculation is a smoothing technique similar to an exponential moving average. It also means that index values become more accurate as the billing period increases.
Wilder's formula normalizes RS and turns it into an oscillator, fluctuating between zero and 100. In fact, the RS graph looks exactly the same as the RSI graph. The normalization step simplifies finding extrema, since the index is in a narrow range. Relative Strength Index is 0 when the average gain is zero. With a 14-period RSI, a zero value indicates that the rate has declined over all 14 periods. There was no growth. The index is 100 when the average depreciation is zero. This means that the course has grown over all 14 periods. There was no fall.
Based on the relative strength index, the Stochastic RSI stochastic oscillator is calculated:
- StochRSI = (RSI - minimum RSI) / (maximum RSI - minimum RSI).
The oscillator relates the RSI level to its minimum and maximum values over a period of time. In the stochastic oscillator formula, instead of the course values, the RSI values are substituted. Thus, Stochastic RSI is an indicator indicator - the second derivative of the exchange rate. Significantly increases the number of signals, therefore, along with it, other technical analysis tools should be taken into account.
RSI indicator: how to use?
The standard number of periods for the relative strength index is 14, which means that it evaluates the last 14 candles, or time intervals.
The indicator compares the average gain with the average loss and analyzes how many of the last 14 candles were bullish or bearish, and also analyzes the size of each candle.
For example, if all 14 candlesticks are bullish, then the index is 100, and if all 14 candlesticks are bearish, then 0 (or almost 100 and 0). An index of 50 would mean that 7 past candles were bearish, 7 were bullish, and average profit and loss were equal.
Example 1. The screenshot below shows the EUR / USD chart. Highlighted in white includes the last 14 price candles. Of these, 13 were bullish and only 1 was bearish, resulting in a value of 85.
Example 2. The screenshot below shows the EUR / USD chart and 3 selected areas of 14 candles each to understand how the relative strength index is calculated.
- The first area highlights a very bearish period of 9 bear candles, 4 small bull candles and 1 candlestick pattern (doji). The RSI of this period is 15, which signals a very strong bearish phase.
- The second section includes 9 bull candles and 5 mostly small bear candles. The indicator of this period was 70, indicating a relatively strong bull trend.
- The third area includes 6 bullish candles, 8 bearish and 1 doji, which leads to an index value of 34, indicating a moderate depreciation.
As you can see, the analysis of 14 candles quite closely matches the RSI for this period. Nevertheless, the indicator is useful in that it reduces the time required for data processing, and also avoids errors during volatile market behavior.
Oversold and overbought
The basic idea is that when the relative strength index shows very high or very low values (greater than 70 or less than 30), the price indicates oversold or overbought. A high index means that the number of bullish candles prevailed over the number of bearish candles. And since the course cannot endlessly stamp only bullish candles, you cannot rely solely on the RSI indicator to determine a trend reversal.
If 13 of the last 14 candles were bullish, and the index far exceeds 70, it is likely that the bulls will retreat in the near future, but you should not rely on the RSI indicator in your forecasts. The screenshot below shows two periods when it entered the oversold area (less than 30) and remained so for a long time. During the first period, the rate continued to fall for 16 days before the index returned above 30, and during the second period, the rate continued to fall for 8 days when the market was oversold.
The default period for calculating the trend strength index is 14, but it can be reduced to increase the sensitivity of the indicator, or increased to reduce it. A 10-day RSI will reach overbought or oversold levels faster than a 20-day RSI.
The market is considered overbought when the RSI value exceeds 70, and oversold when below 30. These traditional levels can also be adjusted to better meet security or requirements. Setting the RSI indicator by increasing overbought to 80 or reducing oversold to 20 will reduce the frequency of signals. Short-term traders sometimes use a 2-period RSI, which allows you to look for overbought above 80 and oversold below 20.
Relative Strength Indicator cannot be used solely to determine likely pivot points. He also points to very strong trends when he remains in the oversold or overbought zone for a long time.
Breakthrough of the line of support and resistance
As already mentioned, the relative strength index allows you to determine strong exchange rate trends. This makes it an excellent tool when trading at support and resistance levels. The figure shows the EUR / USD chart, and the black horizontal line is a well-known level of 1.20 rate, which is the level of support and resistance.
You can make sure that the price several times returned to the level of 1.2. The first time the RSI showed values of 63 and 57. This meant that, although the trend was upward, its strength was insufficient. It is not easy to break through a strong resistance level - a strong trend is needed to overcome it.
The second time the rate returned to the resistance level, the RSI was 71, which indicates a fairly strong bullish trend, but the resistance level resisted again. Until the last segment, when the RSI showed a value of 76, the resistance level was overcome and the RSI rose to 85.
The indicator can serve as a tool for quantifying the strength of the course. Traders using trading algorithms are in dire need of such information, and the relative strength indicator comes in handy.
Divergence RSI
Another area where the RSI indicator is used is the strategy for identifying turning points by searching for divergence. The divergence signals that the course gives are generally not supported by the underlying price dynamics. This is confirmed by the following.
The screenshot below shows two lows. During the first, the indicator was 26, and the movement of the course, preceding this moment, included 8 bearish candles, 3 bulls, 3 doji, the course fell by a total of 1.45%. During the second low, the RSI showed a higher value of 28, and the course included 7 bearish candles, 5 bulls, 2 doji and the rate lost only 0.96%.
Although the course reached a new, lower low, the background dynamics were not so bearish, and the second section was not strong. And the graph confirms this. The second minimum had a higher indicator (28 versus 26), although the course showed that the bears are losing strength. Divergence often breaks down, double divergence is more reliable.
Positive negative reversals
Andrew Cardwell developed a positive-negative reversal system for the relative strength index, which is the opposite of bearish and bullish divergences. Unlike Wilder, Cardwell saw bearish divergence as a bull market phenomenon. In other words, bearish divergences form an uptrend. Similarly, bullish divergences are seen as a bear market phenomenon and indicate a downtrend.
A positive reversal is formed when the indicator reaches a lower low, and the course forms a higher low. The low minimum is not located at the oversold level, but somewhere between 30 and 50.
A negative reversal is the opposite of a positive one. RSI forms a higher high, but the course forms a lower high. Again, a higher one is usually located just below the overbought level at 50-70.
Trend id
The relative strength index tends to fluctuate between 40 and 90 in a bull market (uptrend) with levels of 40-50 serving as support. These ranges may vary depending on RSI parameters, trend strength and underlying asset volatility.
On the other hand, the indicator ranges from 10 to 60 with a bear market (downtrend) with levels of 50-60 as resistance.
Failed swing
The failed swing, according to the author, is a strong sign of an impending reversal. It is a signal that the RSI indicator gives. Its description is as follows. Failed swings are course independent. In other words, they focus exclusively on RSI signals and ignore the concept of divergence. A bullish failed swing occurs when the RSI drops below 30 (oversold), rises above 30, drops to 30, and then breaks the previous high. The goal is to achieve oversold levels and then a higher low above the oversold level.
A bearish failed swing is formed when the index moves above 70, decreases, bounces, does not reach 70, and then breaks the previous low. The goal is the overbought level, and then a lower high below the overbought levels.
The course is more important than the indicator
Universal torque oscillator RSI indicator - time-tested performance. Despite the volatility of the markets, RSI remains as relevant today as it was in the days of Wilder. But time has made some adjustments. Although Wilder considered overbought as a condition for a reversal, it turned out that it could be a sign of strength. Bear divergence still gives good signals, however, traders should be careful during strong trends when it is normal. Despite the fact that the concept of positive and negative reversals somewhat undermines Wilder’s interpretation, its logic makes sense and Wilder himself would hardly refuse to pay more attention to price behavior. Positive and negative reversals put the price trend in the foreground, and the index in the background, as it should be. Bearish and bullish divergences prefer the RSI indicator. How to use these tools depends on the trader.
The RSI indicator is a universal tool for determining trend strength, finding pivot points or breaking support and resistance lines. And although its value can be easily predicted by looking at the last 14 candles, drawing RSI on the course graphs will add stability and confidence in the trade. A quantitative assessment of the strength of the course, its translation into interpreted figures will allow you to more effectively make trading decisions and avoid guesswork and subjective interpretations.