Amongst the most well-known indicators in the trading industry, the Relative Strength Index or simply RSI, informs of price movement strength. This short feature details how the RSI works, how the information that it gives should be understood, and how one should go about using it in trading.
The RSI Indicator
So what is RSI? As already mentioned, the RSI gets its name from its function of informing traders of the strength of price movements. It does so by setting the standard at 14 periods. The 14 periods are represented by the 14 candles on the RSI chart which it evaluates.
The RSI evaluation is done through the comparison of average gain and average loss. The past 14 candles would be analyzed to determine either Bullishness or Bearishness. Each candle is also evaluated for its size.
RSI Sell and Buy Signals
Here are a few examples that would help the trader understand what the RSI does and how it actually works:
- The Bearish period is seen in the first area. It has 5 candles that are Bearish and 7 that are Bullish. Signaling a Bullish phase, the RSI for this period is at 84.
- Six (6) candles that are Bullish and 5 that are Bearish are seen in the second area. This resulted into an RSI of 60. What this signals is a Bullish that is moderate. The balance is equal. There is also a slight Bullish surplus.
- The third area sees 6 Bullish and 9 Bearish candles. For this period, the RSI is at 25. As the Bears dominate the chart, this indicates a Bearish move.
The Truth Behind “Oversold” and “Overbought”
Given what has been discussed previously, the concepts, “Oversold” and “Overbought” are put into question. To make it simple, we’ll say this: Oversold and Overbought do not signal that prices will turn.
To ground this, one must understand that a high RSI implies that Bullish candles dominate. Another thing to note is that while prices will not stay for long, assuming that because the RSI is showing Overbought and Oversold conditions means that prices would reverse, is not healthy.
The RSI may also be used to find divergences. This signals that the prices shown in the chart may not be supported by the price dynamics.
The RSI Divergence is an efficient means of showing the strength of a trend. For a clearer picture, refer to the chart below:
As shown, the downtrend is strong. This is confirmed by the RSI as it shows a lower RSI upon the falling of prices from 22 to 18.
Divergence is basically when opposite signals are being shown by the price action and the indicator. The trader benefits from the divergence as it helps him or her that,
- The trend strength is losing ground
- One side of the market participants is slowly departing from the game
The Takeaway: Trade Using RSI
The takeaway from this is that the RSI is an efficient instrument. The catch? Despite its value being easily derived by simply looking at the previous 14 candles, when you use RSI, your trading will gain further guidance and stability. This will permit you more reliable trading decisions as you will not rely solely on mere interpretation.