Relative Strength Index (RSI)
Technical analysis (TA) is a method of forecasting future market trends and price movements by studying past market events. Technical analysis is widely used in both traditional and cryptocurrency markets. One of its most popular tools is the RSI.
The Relative Strength Index (RSI) is a TA indicator developed in the late 1970s as a tool to study the movement of stocks over a certain period of time. It is an momentum oscillator that measures the magnitude of price movements as well as their velocity.
The Relative Strength Index was created by J. Welles Wilder in 1978. It was introduced in his book "New Concepts in Technical Trading Systems," alongside other TA indicators such as the Parabolic SAR, Average True Range (ATR), and the Directional Movement System (ADX).
Before becoming a technical analyst, Wilder worked as a mechanical engineer and builder. He began trading stocks around 1972 but not very successfully. Several years later, Wilder compiled his research and trading experience into mathematical formulas and indicators, which were later adopted by many traders worldwide. The book was written in just six months, and despite being dated to the 1970s, it remains a reference for many analysts and traders.
How Does the RSI Indicator Work?
By default, the RSI measures the changes in the price of an asset over 14 periods (14 days on daily charts, 14 hours on hourly charts, etc.). The formula divides the average price gain by the average price loss, and then the resulting data is ranked on a scale from 0 to 100.
As mentioned, RSI is a momentum indicator in technical trading that measures the rate of change of price (or data). When momentum increases and the price rises, it indicates active buying of the asset in the market. If momentum decreases, it's a sign of increasing selling pressure.
RSI simplifies the task of determining overbought or oversold market conditions. It evaluates the price of an asset on a scale from 0 to 100 over 14 periods. If the RSI reading is 30 or below, it suggests that the asset is likely close to its daily low (oversold), while a reading above 70 suggests that the asset's price is likely close to its daily high (overbought) for that period.
Although the default RSI settings include 14 periods, traders can adjust this number to increase sensitivity (fewer periods) or decrease sensitivity (more periods). Thus, a 7-day RSI is more sensitive to price movements than one that considers 21 days. When developing short-term trading strategies, RSI signal levels are sometimes evaluated at 20 and 80 marks (instead of 30 and 70) to reduce the likelihood of false signals.
How to Use RSI Based on Divergences
In addition to RSI readings at 30 and 70, which can indicate potentially overbought and oversold market conditions, traders also use RSI to attempt to predict trend reversals or identify support and resistance levels. This approach is based on so-called bullish and bearish divergences.
Bullish divergence is a condition where price and RSI indicators move in opposite directions. For example, the RSI indicator rises and creates higher lows, while the price falls and creates lower lows. This is called a "bullish" divergence and indicates strengthening buying pressure despite a downward price trend.
Bearish divergence may indicate that despite the rising price, the market is losing momentum. Thus, the RSI indicator falls and creates lower highs, while the asset's price increases and creates higher highs.
However, one cannot rely on RSI divergence during pronounced market trends, as a strong downward trend can cause many bullish divergences before reaching a minimum. Because of this, RSI divergence is best applied to less volatile markets with sideways movements and weak trends.
Final Thoughts
When using the Relative Strength Index (RSI) indicator, several important factors need to be considered, such as strategy, values (30 and 70), and bullish/bearish divergences. However, it should be remembered that no technical indicator is 100% effective, especially if used in isolation. Therefore, traders should consider using the RSI indicator in conjunction with other indicators to avoid false signals.