Relative Strength Index (RSI) is a hot topic in the world of trading. Since it is one of the most talked about trading indicators there are polarizing views of its usefulness. There are many successful traders who focus only on RSI and others who consider RSI a waste of time. This is because there are many factors to trading and how you use a particular indicator. My hope is that after reading this post, you’ll understand how RSI works, why RSI is interpreted in a variety of ways, and how you might be able to use it in your trading journey.

RSI is used to identify potential reversal points in the market. The prevailing theory is that price momentum will eventually run out and the market will then move in the opposite direction. If you want to dive straight into the source material, J. Welles Wilder publicly shared the creation of RSI in his book, New Concepts in Technical Trading Systems. (1)

n = period length

AvgU = average of all up moves in the last n price candles

AvgD = average of all down moves in the last n price candles

By default, RSI uses a 14 period length. This means that when RSI is set to 14 it will calculate the current RSI value based on the last 14 periods.

Wilder also applies a SMMA, simple or modified moving average to the period length. You may come across other calculation methods because some traders like to use an exponential moving average (EMA), or simple moving average (SMA), instead of a SMMA.

To see in more detail how RSI is calculated, check out: RSI 102

In order to understand what RSI is telling the user; Wilder turns the number into an index that ranges between 0 and 100.

A high RSI will mean that recent moves up have been much greater than the recent moves down and likely indicative of a bullish or possibly overbought market. Conversely, a low RSI will mean that relative strength is low and recent moves down have been much greater than recent moves up resulting in a bearish or possibly oversold market.

The calculation above visually shows up as an oscillator. An oscillator is intended to construct high and low bands between two extreme values. Below is an example of the oscillator in action below its candle chart.

The extreme values of the RSI oscillator are considered to be “Overbought” and “Oversold” areas. RSI is widely considered “Overbought” when its value is above 70 and “Oversold” when its value is below 30. You can be more selective or more loose with the levels if you want.

Here are some examples using > 70 and < 30 as our levels:

RSI in the image below shows this ticker reaching an “Overbought” state on June 25th and then an “Oversold” state on August 19th. In this example, RSI does a good job as price declines following June 25th and then price increases following August 19th.

Here is an example where RSI returned quickly to the oversold region after leaving it. If you were to buy on January 27th when the stock first turned “Oversold” and then waited too long to sell you potentially could go through another -35.06% price decrease. Here price declines into the “Oversold” area 3 additional times before price begins to make a meaningful rise in price.

This shows that while RSI can be useful as a data point, it is important to consider the status of other indicators before acting too quickly.

In order to spot divergences, you’ll need to understand how to identify higher highs. The first step is finding our previous high, where human opinion intervenes. Depending on how many candles you are analyzing you might have a different answer. For example, if we opened the chart below to find the previous high we’d have 4 possible options, which I’ve circled. All of them would be correct choices, it is up to you to decide which high you want to choose as your previous high for the next step.

In the next step, all we are doing is looking for price to move above the previous high we picked. When that happens it will mean we have made a higher high. In the below example, if we used the most recent high we circled above, then we would have a made a higher high on the latest circled candle.

The inverse study can also be done to find a lower low.

There is no right way to find higher highs or lower lows. It is up to user interpretation of how they want to find them. Maybe they make mathematical rules or maybe they just eyeball the chart.

Now, back to how RSI divergences look at higher highs and lower lows.

Since RSI includes previous values it means that if there is a large price movement on the current candle, it might not be represented in the RSI value yet. When that movement is large enough and at key support levels it can create a divergence.

The technical definition of divergence as it relates to RSI is when there is a mismatch between the information we are getting from the price and RSI.

A bearish RSI divergence occurs when the price makes a new higher high, but RSI doesn’t.

A bullish RSI divergence occurs when price makes a new lower low, but RSI doesn’t.

In the image below we see price make a higher high, but when we look at RSI we can see that it has made a lower high. A bearish divergence! And look price responds with a bearish movement.

Below is an example of a bullish divergence where price increases after price makes a new lower low, but RSI doesn’t.

Some traders will look at previous highs and lows for RSI, found in the same way as we did in the previous section, to determine future actionable movements. If RSI breaks through a previously identified high then it can be considered a breakout and bullish opportunity. Conversely, if RSI breaks below a previously identified low then it can be considered a breakdown and bearish opportunity.

Here is an example of a breakout where we see a previous high line as shown by the red dotted line on the RSI chart. RSI then has a breakout above that high line creating a bullish opportunity. That bullish opportunity resulted in price movement to the upside as shown by the white arrow where it occurred and the price candles moving upward after.

Here is an example of a short breakout to show you how difficult it is to find these and why it takes some skill and understanding of what constitutes an important high level and when to exit a trade.

In the Candleverse, we visualize data by grouping each candle together based on their value. We chose 3 groups for RSI:

0-30 = Oversold

30-70 = Regular

70+ = Overbought

Here is a run of 1 day BTC/USDT for the last year. You can see that each group has been assigned a candle type. For example, a C3 candle type is for “Regular” RSI candles with a value of 30-70. We show a C3 above each candle that is in the “Regular” group and we show a summary of all the C3 candles in the column below the chart. So this tells us that there were 323 “Regular” RSI candles in the last year.

There are a variety of ways that traders use RSI in their trading strategies. A trader might decide to sell when RSI is overbought, buy when a bullish divergence occurs, sell when RSI breaks down below its previous low, or buy when RSI leaves oversold.

Using the Candleverse, we have done studies to see if these commonly used ideas and more have been historically successful. All of the ideas and links to their accompanying studies are covered in RSI 103: How to use RSI.

Despite changes in volatility and markets since its creation in 1978, RSI has continued to be a tool widely used and respected among traders. Based on what I’ve learned, seen, and backtested you can be successful in using RSI, but it depends on your understanding of the way it interacts with price and it integrates into your trading strategy.

It is important to remember that RSI alone cannot provide a comprehensive view of the market for an asset and can sustain a prolonged overbought or oversold status.

Jump into the Candleverse and discover how different indicators and assets have interacted with RSI in the past. RSI Explore Link

Watch a deeper dive video from Candleverse: [LINK]

Continue to RSI 102: How do you calculate RSI?

Sources

(1) - Check out the original text: https://www.amazon.com/New-Concepts-Technical-Trading-Systems/dp/0894590278