What is RSI?
The Relative Strength Index (RSI) is one of the most popular technical indicators in day trading. RSI is a momentum oscillator that measures the speed and change of price movements over a given time period. It is used in all markets from stocks to forex.
The RSI indicator, like most oscillators, is typically plotted underneath a price chart (see below).
To trade with RSI means using movements in the indicator in conjunction with movements in the market price to find buy and sell signals as well as determine the momentum of the market.
What is a momentum indicator?
A momentum indicator measures the speed and change of price movements. It is a second derivative of the price. If the price is rising it simply tells you the price is moving higher. If momentum is rising, it tells you the price is moving higher at a greater speed. Another way to explain it is that momentum is measuring the ‘slope’ of a price trend.
Why is momentum important?
Momentum tends to lead the price, meaning it changes first. The RSI in trading is known as a leading indicator.
This can be better understood if you think of how momentum occurs in nature. If you throw a ball up in the air, the ball will first slow down (momentum is falling) before it eventually stops at the top and starts to fall. For a day trader, it is very useful to understand when the market might be about to turn before it does.
Trading with RSI explained
There are certain repeatable behaviours of the RSI that can be recognised and used as valuable information for trading, just like chart patterns in the underlying price.
There are four mains ways that traders could use to form an RSI trading strategy
Overbought / Oversold
The RSI indicator oscillates between zero and 100 and can never have a reading of less than zero or more than 100. The 70 and 30 levels are traditionally viewed as the bands that indicate whether an asset is overbought or oversold.
Overbought means momentum has become ‘too strong’ and likely about to reverse lower.
Oversold means momentum has become ‘too weak’ and is likely about to turn higher.
As we have already discussed, momentum tends to lead the price. So 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.
Traders can wait 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.
Traders can 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.
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 can present short-term sell and buy signals.
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.
Since Welles Wilder developed the RSI, other technical analysts, including Constance Brown and Andrew Cardwell, have found new trading signals the indicator can provide. Learn more in our guide on unorthodox RSI trading strategies.
RSI indicator settings
The RSI indicator can be used on any candlestick chart or bar chart time frame, including minutes, hours, days and weeks. It’s worth noting that the smaller the timeframe used for calculation, the more volatile the RSI will be.
The RSI can also be calculated over different time periods. The standard setting is 14 periods, but some traders use custom time frames like two periods, nine periods or 50 periods.
Who invented the RSI
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.
Wilder was trading stocks and commodities and faced a problem. He wanted to know if the price was already too expensive to open a long position in an uptrend, or too cheap to open a short position in a downtrend. He solved his problem with the RSI.
Today, the RSI has become one of the most popular oscillator indicators and is used by many traders, with varying RSI trading strategies.
How is RSI calculated?
We will go through the mathematics briefly, including the RSI formula. It is not necessary to remember the RSI calculation to use RSI trading strategies, but it helps to conceptualise what the indicator is showing.
The RSI is calculated by normalising the relative strength factor (RS).
Relative strength 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 Welles Wilder) 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.
The RSI is a leading indicator, designed to 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.
RSI vs Stochastic: What’s the difference?
The RSI and stochastic oscillators are both momentum indicators and two of the most popular indicators for technical analysis. However, the different mathematical formulas create different results.
The RSI is looking at the average gains against the average loss over a set number of periods. But the stochastic oscillator considers the closing price relative to the highest high and lowest low within a given timeframe. The stochastic tends to get overbought and oversold more often than the RSI, providing more trading opportunities but also more false signals.