Learn to Trade
by Rob
December 2, 2016 Updated October 17, 2023
111
5 votes
Reading time: 3 minutes
Sometimes, in addition to analysing pure price action on the charts, technical traders will utilize mainstream or even sentiment indicators. This is to confirm or validate their trade idea. Although there are many, few are more popular than the Relative Strength Index (RSI). Given its reputation for accuracy and reliability across all markets, it is easy to understand why.
Table of Contents
- Relative Strength Index Explanation
- Relative Strength Index (RSI)
- 2 Distinct Applications of the RSI
- Two primary applications of the Relative Strength Index
- Conclusion
The RSI alone is not enough to generate a valid buy or sell signal. Yet it is still one we like to add as a chart supplement. One primary advantage of the RSI is that it gets charted independently. As a result it can be consulted without blurring price action on the actual chart. Find out what the Relative Strength Index (RSI) signifies. Also how it can be applied by technical analysis traders across all markets, such as cryptocurrency trading.
Takeaways
What is the Relative Strength Index (RSI)
How it can help you trade successfully
Why it can help you reduce your trading losses
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Relative Strength Index Explanation
By definition, the Relative Strength Index (RSI) is a momentum or volume indicator. It is used to reflect the overbought or oversold nature of a particular market or asset. It is calculated as follows:
Relative Strength Index (RSI) = 100 - 100 / (1+RS)
RS = Average Gain / Average Loss over 'x' number of periods, like the prior 14 days, for example
The "typical" range for RSI readings is traditionally 30-70. The 70+ area is considered "extremely overbought". Readings of 30 or lower are considered "extremely oversold." Some traders use 80 and 20 for even greater confirmation, though.
A graphical representation of the Relative Strength Index (RSI) (see bottom panel) on an historical EURUSD price chart (top panel) is shown here:
Relative Strength Index (RSI)
Source: AboutCurrency.com
One important item of note is that the Relative Strength Index (RSI) is easily confused with, but is not the same as relative strength. Relative strength measures two separate markets or assets using a ratio line. This isto determine the asset for which price is performing the strongest and weakest, respectively.
2 Distinct Applications of the RSI
With the above chart as a guide, it is clear to see how obtaining an RSI reading is quite simple and straightforward. However, different traders tend to use information from the RSI differently. Some traders taking trades based only on extreme RSI readings. Others simply use the RSI as a potential confirmation signal once a valid price chart pattern is generated on the chart.
Two primary applications of the Relative Strength Index
Direct RSI Buy or Sell Signals: RSI at or near the 30 (oversold) level could be taken as a buying opportunity (see grey shaded area above). This is particularly the case if the price is also at a notable low level. Conversely, an RSI reading at 70 or above could represent a sell signal for the asset in question. (see pink shaded areas above).
This would be the case with price at a recent or period-based high as well. These scenarios represent potential reversal trades. These are low probability and high risk, but are also worthwhile opportunities from time to time.
RSI Divergence: RSI divergence is present whenever the asset, crypto, or currency pair in question is making new highs or lows, but the RSI is not. This might suggest that traders and investors have yet to pile into a momentum move at full force. This leaves additional room for said move to continue to either the upside (if bullish divergence) or downside (if bearish). This scenario might be present, when buying dips or selling rallies within an overall uptrend or downtrend.
Conclusion
As with widely followed strong technical signals, such as moving averages, and candlestick patterns, you should not rely on the relative strength index. Technical trading techniques are there to assist you, they are not going to give you the answer. As a result, whilst direct signals from the Relative Strength Index (RSI) are not valid alone, RSI divergences can be especially useful for buying and selling long-term trend moves.
When learning to trade, understanding that disciplined traders will be using these signals to trade can help you. If you understand what others are doing, you avoid getting burnt by trading against the trend. Essentially the Relative Strength Index (RSI) should help reduce your mistakes!
