RSI trading strategy: an educational guide

Learn how to use the relative strength index (RSI) with our trading strategy guide. Explore the RSI indicator's origins, formula, and its use in combination with other technical analysis tools.

The relative strength index (RSI) is a widely-used indicator used by traders in technical analysis that evaluates the strength of a financial instrument’s price movement over a given time period. It measures the speed and change of price fluctuation on a scale of 0 to 100, providing insights into overbought or oversold conditions, as well as potential trend reversals. 

RSI can be used for trading all markets and asset classes, from stocks to foreign exchange (forex), with a variety of RSI trading strategies to choose from.

The RSI was formulated by mechanical engineer turned trader and technical analyst, J. Welles Wilder Jr., which he first revealed in his 1978 book, "New Concepts in Technical Trading Systems." 

Like most oscillators, RSI is typically plotted underneath a price chart. It can be used on any candlestick or bar chart timeframe, including minutes, hours, days and weeks. 

The RSI can also be calculated over different time periods. The standard setting is 14 periods, but some traders can use custom RSI indicator settings like two periods, nine periods or 50 periods. For example, to optimise RSI for day trading, traders may adjust the settings to a shorter lookback, such as 7 or 10 periods, to increase sensitivity to recent price changes. 

^{*Past performance is not a reliable indicator of future results.}

By comparing the magnitude of recent gains to recent losses, the RSI generates a value from 0 to 100 that reflects the strength or weakness of the asset’s price momentum. 

• When the RSI value rises above 70, it is generally considered to be overbought, signalling that the asset may be overvalued and a price correction may be imminent.

• When the RSI value falls below 30, it is considered to be oversold, indicating that the asset may be undervalued and a price rebound could be on the horizon. 

How is RSI calculated?

It is not necessary to remember the calculation to use RSI trading strategies as the indicator is typically embedded in a trading platform, but it helps to conceptualise what the indicator is showing.

The RSI is calculated by normalising the relative strength factor (RS). RS is measured by average gain divided by average loss.

The average gain is the sum of the upward price changes over last X time periods (typically 14 as recommended by J. Welles Wilder Jr.) divided by the number of periods to attain the average. 

The average loss is the sum of downward price changes over the same number of periods, divided by that same number of periods. 

The relative strength factor (average gain divided by average loss) is then converted to a relative strength index between 0 and 100, to produce the RSI formula.

An RSI trading strategy is a set of rules and techniques that utilises the RSI indicator to identify potential trading entries based on overbought and oversold conditions or momentum shifts. There are four key ways to use the RSI indicator in trading.

Overbought and oversold 

As we have already discussed, if the RSI indicator shows an asset has become overbought and then starts to point lower, it suggests the price might follow it downwards. Likewise, if RSI is oversold and then starts to point higher, the price could be about to turn higher too.

Those following this RSI trading strategy may consider waiting until the RSI falls below the 70 from an overbought condition level to take a possible short position. Then when the RSI rises above 30 from oversold conditions, the idea is to take a long position.

^{*Past performance is not a reliable indicator of future results.}

50-crossover

Traders could use the RSI 50 level (the centreline) to confirm that a price trend is occurring. According to this strategy, a downward trend is confirmed when the RSI crosses from above 50 to below 50. Similarly, an upward trend is confirmed when the RSI crosses above 50.

^{*Past performance is not a reliable indicator of future results.}

Divergence

Another way to trade with RSI is to look for divergence between the RSI and the market price. Put simply, traders are looking for situations when momentum moves in the other direction to the price, signalling a possible turning point.

When the price hits a ‘higher high’ but the RSI makes a ‘lower high’ – this is known as bearish divergence.

When the price makes a ‘lower low’ and the RSI forms a ‘higher low’ – this is known as bullish divergence.

When divergence occurs, the theory states that there is a higher probability of price reversing. This could present potential short-term sell and buy signals.

^{*Past performance is not a reliable indicator of future results.}

RSI failure swings

This is a similar concept to divergence but on a much smaller scale. The ‘swings’ are small highs and lows that a price makes when it is in a trend. The RSI tends to track the highs and lows made in the price. 

Uptrends see higher highs and lows. Downtrends see lower highs and lows. If RSI swings lower but the price continues higher, this could be a sign of a short-term trend reversal.

^{*Past performance is not a reliable indicator of future results.}

Traders may choose to use RSI in conjunction with other indicators to enhance their market analysis and gain a more comprehensive understanding of price movements. Below are some of the popular indicators that may complement an RSI trading strategy.

• Moving averages (MA)

Traders often use moving averages (MA) in conjunction with RSI to identify trends and potential entry or exit points. For example, when the price crosses above a moving average and RSI moves out of oversold territory (above 30), it may signal a potential long entry. Conversely, when the price crosses below the moving average and RSI moves into overbought territory (above 70), it could indicate a short entry point.

• Bollinger Bands®

By combining Bollinger Bands® with RSI, traders could gain additional confirmation of overbought or oversold conditions. When the price touches the upper Bollinger Band® and RSI is above 70, it may suggest that the asset is overextended and due for a pullback. Similarly, if the price touches the lower Bollinger Band® and RSI is below 30, it might indicate an oversold condition and a potential buying opportunity.

• MACD 

Using moving average convergence divergence (MACD) together with RSI could provide further confirmation of trend changes and momentum shifts. For instance, if RSI shows a bullish divergence (price makes lower lows while RSI makes higher lows) and MACD experiences a bullish crossover (the MACD line crosses above the signal line), it may reinforce the likelihood of a potential trend reversal to the upside.

• Stochastic oscillator

The stochastic oscillator, like RSI, identifies overbought and oversold conditions. By comparing the two indicators, traders could look for confirmation or divergences to better gauge potential market reversals. For example, if both RSI and stochastic oscillator move from oversold to overbought territory, it may strengthen the case for an upward price movement.

• Fibonacci retracements

Combining Fibonacci retracements with RSI could help traders identify potential support and resistance levels during price corrections. If RSI reaches oversold levels near a significant Fibonacci retracement level, it could signal a higher probability of a price rebound at that level, providing a potential entry point for long positions.

False signals: The RSI is a leading indicator, designed to potentially get you into a profitable trade earlier than lagging indicators. However, leading indicators are less reliable and can often produce false signals. This is because not every change in momentum means price will change direction.

Size of reversal unknown: The RSI indicator signalled many turning points in the markets over the years, but it does not predict how big or small the following price move will be. The RSI might be signalling a top or bottom or simply a temporary reversal in the direction of a stock’s price.

In conclusion, RSI is a popular technical analysis tool used to measure the strength of price movements for various financial instruments. Developed by J. Welles Wilder Jr., it gauges overbought or oversold conditions and potential trend reversals, providing valuable insights for traders.

The RSI can be applied to different timeframes and time periods, with the standard setting being 14 periods, although traders may customise. For example, RSI settings for daytrading are typically on a shorter lookback, such as 7 or 10 periods, to increase sensitivity to recent price changes. 

RSI strategies include identifying overbought/oversold conditions, 50-crossover, divergence, and failure swings. Traders often use RSI in conjunction with other indicators, such as moving averages, Bollinger Bands®, MACD, Stochastic Oscillator, and Fibonacci retracements, to enhance market analysis and support decision-making.

However, RSI does have limitations, including the possibility of producing false signals and not predicting the magnitude of price reversals. Despite these drawbacks, RSI remains a useful indicator for traders seeking to navigate the complexities of financial markets.