RSI Trading Strategy (Relative Strength Index)
In this article, I am going to discuss the RSI indicator also known as the Relative Strength Index Trading Strategy. Please read our previous article, where we discussed Option Chain Analysis in detail. 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?
The Relative Strength Index (RSI), developed by J. Welles Wilder. Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between zero and 100
How does the RSI indicator work?
Let’s understand the formula .how it works? The logic behind the RSI. RSI indicator is calculated on the closing price. We can define bullish and bearish price 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 very first calculations for average gain and average 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 to 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 take note of is that the higher your average gain, the higher your RSI is going to be. Make sense?
Suppose in the above example average gain is 15 and the average loss is 5
RSI will be (15/20) x 100= 75
So, when RSI is at 50, it means Average gain is equal to Average loss.
RSI goes up: When your average gain is greater than your average loss in a particular lookback period, and this pretty much means that the size of your bullish candles is larger than the bearish candles.
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 calculation for the Relative Strength Index (RSI) indicator, I think their calculation used 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 When above 70 and oversold when below 30. These levels can also be changed if necessary to better fit the security. For example, if security is repeatedly reaching 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 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 trend using RSI
If RSI above 50. This tells you is 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 RSI 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 isn’t confirmed by the RSI, this divergence can signal a price reversal.
Price makes 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 RSI does not confirm the lower low and 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.
Here, in this article, I try to explain RSI Trading Strategy. I hope you enjoy this RSI Trading Strategy article. Please join my Telegram Channel to learn more and clear your doubts. https://t.me/tradingwithsmartmoney.