RSI (Relative Strength Index) Trading Strategy
In this article, I will discuss the RSI indicator, the Relative Strength Index (RSI) Trading Strategy. Please read our previous article discussing Option Chain Analysis in Trading. As part of this article, you will learn the following.
- What is RSI?
- How Does the RSI Indicator Work?
- 4 Uses of RSI
What is the Relative Strength Index?
J. Welles Wilder developed the Relative Strength Index (RSI). Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between zero and 100. The Relative Strength Index (RSI) is a popular momentum oscillator used in technical analysis to measure the speed and change of price movements. Here’s a basic RSI trading strategy:
- Indicator Setting: Set the RSI indicator on your trading platform. The standard setting is a 14-period RSI, which can be applied to any time frame (daily, hourly, etc.).
- Overbought and Oversold Levels: Identify overbought and oversold levels on the RSI scale. Traditionally, readings above 70 indicate overbought conditions, suggesting a potential sell signal, while readings below 30 indicate oversold conditions, suggesting a potential buy signal.
- Confirmation with Price Action: Confirming RSI signals with price action is important. For instance, if RSI is oversold, look for a bullish reversal pattern in the price to confirm a buy signal.
- Divergence: Watch for divergence between RSI and the price. If the price makes a new high, but the RSI doesn’t, it’s a bearish divergence, indicating potential selling opportunities. Conversely, if the price makes a new low, but the RSI doesn’t, it’s a bullish divergence, indicating potential buying opportunities.
- Entry and Exit Points: Enter a trade when the RSI gives a clear overbought or oversold signal that other indicators or price patterns confirm. Set exit points at which you’ll take profit or cut losses.
- Risk Management: Always use stop-loss orders to manage your risk. You can set your stop-loss just above a recent high for a sell trade or below a recent low for a buy trade.
- Backtesting and Adaptation: Before applying the RSI strategy in live trading, backtest it on historical data. It’s also important to adapt the strategy based on your trading asset and current market conditions.
How Does the RSI Indicator Work?
Let’s understand the formula. How does it work? The logic behind the RSI. The RSI indicator is calculated on the closing price. We can define bullish and bearish prices on a closing chart as follows:
- If the current closing price is higher than the previous closing price, = Bullish trend
- If the Current closing price is lower than the previous closing price, = Bearish trend
The first calculations for average gain and loss are simple 14-period averages(default period). The first question is, what is the average gain? Let me give you a very simple example.
Above is a chart connecting 14 closing prices. We are calculating the average gain and loss over the last 14 periods. Let us calculate gains and losses on this chart.
- First Average Gain = Sum of Gains over the past 14 periods
- First Average Loss = Sum of Losses over the past 14 periods
In the above chart,
Bullish readings (Gain) are = 10,10,10,10,10,10 and 10
Bearish reading (Loss) are = 10,10,10,10,10,10 and 10
Let us calculate the simple average price of the gains & losses:
Bullish average = (10+10+10+10+10+10+10)/7=10
Bearish average = (10+10+10+10+10+10+10)/7=10
So average gains were 10 points and average losses 10 points.
How do we know how strong the bulls are?
The average of losing bars plus the average of winning bars was =10+10=20
The average gain was 10
So, RSI will be (10 / 20) x 100= 50
The key thing to note is that the higher your average gain, the higher your RSI will be. Make sense?
Suppose in the above example, the average gain is 15 and the average loss is 5
RSI will be (15/20) x 100= 75
So, when the RSI is at 50, the Average gain equals the Average loss.
RSI goes up: When your average gain is greater than your average loss in a particular lookback period, this pretty much means that the size of your bullish candles is larger than the bearish ones.
RSI goes down: When your average gains are smaller than your average loss in a particular look-back period. This means the size of bearish candles is larger than the bullish candles. In other words, the RSI indicator measures the momentum of price or trend.
(Disclaimer: I used a very simplified version of the Relative Strength Index (RSI) indicator calculation. I think their calculation is a little bit more complicated. But again, the concept is the same.)
The default look-back period for RSI is 14, but this can be changed. The look-back period for RSI is lowered to increase sensitivity or raised to decrease sensitivity. 7- Period RSI is more likely to reach overbought or oversold levels than 14- period RSI.
Uses of Relative Strength Index Trading Strategy
RSI shows overbought or oversold
- RSI is when above 70 and oversold when below 30. These levels can also be changed if necessary to fit the security better. For example, if security repeatedly reaches the oversold level of 30, you may want to adjust this level to 20.
- Relative Strength Index (RSI) overbought and oversold readings work best when prices move sideways within a range.
- During strong up trends, the RSI may remain overbought for extended periods.
So consider only oversold when the trend is strong. Reverse for a strong downtrend.
- RSI also often forms chart patterns(like price chart patterns) that may not show on the underlying price chart, such as double tops and bottoms, support resistance, and trend lines.
Identifying Trends Using RSI
Suppose the RSI is above 50. This tells you that the average gain is larger than the average loss. You can conclude that it’s in an uptrend. In an uptrend, the RSI tends to remain in the 40 to 80 range, with the 40-50 zone acting as a support zone.
If the RSI is below 50. This tells you that the average loss is greater than the average gain, and you can conclude that it’s in a downtrend
During a downtrend, the RSI tends to stay between the 20 to 60 range, with the 50-60 zone acting as a resistance zone. These ranges will vary depending on the RSI settings and the strength of the security’s trend.
If prices make a new high or low that the RSI doesn’t confirm, this divergence can signal a price reversal.
Price makes a lower low while RSI makes a higher low. Why?
A bullish divergence occurs when the price makes a lower low, and RSI forms a higher low. If the RSI does not confirm the lower low, this shows strengthening momentum. It means there were gains in between while the price made new lows, but the gains prevented the RSI from making a corresponding lower low. The logic is reversed for the Bearish divergence.
Relative Strength Index Trading Strategy
The Relative Strength Index (RSI) Trading Strategy is a momentum oscillator that measures the speed and change of price movements. It’s commonly used in trading to identify overbought or oversold conditions in a market. Here’s a basic outline of the Relative Strength Index Trading Strategy:
Understanding RSI Values:
- RSI ranges from 0 to 100.
- Values above 70 indicate a market is overbought, while values below 30 suggest it’s oversold.
Buy and Sell Signals:
- Buy Signal: When the RSI falls below 30, it indicates an oversold condition. Traders might consider this a buy signal, expecting the price to rebound.
- Sell Signal: Conversely, when the RSI rises above 70, it suggests an overbought condition. Traders might view this as a signal to sell, anticipating a price drop.
- RSI divergence occurs when the RSI direction differs from the price trend.
- Bullish Divergence: When the price hits a new low, but the RSI does not, it could indicate an upcoming bullish reversal.
- Bearish Divergence: If the price hits a new high, but the RSI doesn’t, a bearish reversal might be imminent.
Combining with Other Indicators: For better accuracy, RSI is often used in conjunction with other indicators like Moving Averages or MACD (Moving Average Convergence Divergence).
Time Frame: RSI can be applied to various time frames. Short-term traders might use a 14-day RSI, while long-term traders might prefer a longer period, like 21 or 28 days.
Risk Management: Like any trading strategy, using RSI requires careful risk management. It’s important to set stop-loss orders to limit potential losses.
Backtesting and Adjustment: Traders should backtest the RSI strategy on historical data to check its effectiveness. Adjustments may be needed based on asset class and market conditions.
In the next article, I will discuss the BTST Trading Strategy (Buy Today, Sell Tomorrow). In this article, I try to explain the RSI Trading Strategy. I hope you enjoy this RSI Trading Strategy article. Please join my Telegram Channel, YouTube Channel, and Facebook Group to learn more and clear your doubts.
About the Author: Pranaya Rout
Pranaya Rout has published more than 3,000 articles in his 11-year career. Pranaya Rout has very good experience with Microsoft Technologies, Including C#, VB, ASP.NET MVC, ASP.NET Web API, EF, EF Core, ADO.NET, LINQ, SQL Server, MYSQL, Oracle, ASP.NET Core, Cloud Computing, Microservices, Design Patterns and still learning new technologies.