Relative Strength Index – Your Key to Strong Signals
Traders and analysts are divided into two major groups. The first one prefers the fundamental analysis; the second one is fond of the technical indicators. However, there is a third group. They combine both fundamental and technical factors. Nevertheless, all of them should know the crucial points of each type of analysis.
In this article, we will talk about one of the most significant technical indicators – the RSI indicator.
What Does RSI Stand For?
The Relative Strength Index was created by J. Welles Wilder. Before he became a technical analyst, he worked as a mechanical engineer. This fact helped him develop not only the RSI but other indicators, such as the Average Directional Index, Average True Range, and Parabolic SAR.
As for the RSI, the RSI indicator is a price oscillator. But before we go into more detail, let us explain what the oscillator is. If you open a trading platform, for example, MetaTrader and choose the indicators tab, you will see a list of indicators that will be grouped by their functions or the name of the creator. So, you may see trend indicators, oscillators, volumes, and Bill Williams.
Oscillators are technical indicators that vary over time between two main points (key levels) and determine market conditions. Thus, they show if the market is overbought or oversold.
It’s time to get back to the RSI. We’ve mentioned the relative strength index is an oscillator that shows the strength of the price, counting the speed and magnitude of the recent price changes and depicting overbought and oversold market conditions.
If the concept is still tricky, let’s move on to examples.
How Does RSI Work and How to Read It?
As we said earlier, there are different types of indicators. They differ with functions, names, and placement. For example, take a look at the chart below. Trend indicators are applied on the chart, while oscillators are located in a window below the chart.
Same with the relative strength index. It’s placed in a window below the price chart. As you can see, there is a line, the index, and two levels – 30 and 70. The indicator shows whether the market sentiment.
RSI Indicator: Buy and Sell Signals
The first and primary RSI function is to determine the market condition. You’ll need to look at the indicator. The 30 level is a border of the oversold area. A break below this level signals sellers (or “bears”) prevail in the market. This situation means the asset is oversold, and traders can expect a market reversal.
Remember one crucial aspect of trading: rise or fall of the asset can’t last forever, a reversal will take place soon. However, the indicator will give you a signal only if it crosses the 30-level bottom-up. It will mean the reversal is taking place. Nevertheless, don’t blindly believe one indicator. Get a confirmation from a candlestick or another indicator, for example, MACD. As soon as you get more proof, you can go long.
The second crucial level of the indicator is the 70 level. It’s a vital point in the overbought area. If the indicator enters the area above the 70 level, it means there are too many buyers (or “bulls”) in the market, and the asset is overbought. Thus, traders can expect a reversal down. Again, the signal appears only if the index crosses the 70 line from top to bottom. Remember the confirmation. If you get it, open a short or sell position.
Note: although the indicator gives a signal when the market is oversold or overbought, you should look at the situation as a whole. In times of the strong trend, the indicator can stay in the oversold/overbought area for a long time. If you notice a strong downtrend, don’t wait until the RSI crosses the 30 level from bottom to top. Sell until the indicator is in the oversold areas. The same rule applies to the overbought zone. Buy within the strong uptrend. We can find a good example in the crypto market.
On the daily chart of BTC/USD, you can see that the RSI indicator was in the overbought area several times. However, the direction of the pair didn’t change due to the strong uptrend. Moreover, if the indicator doesn’t go far in overbought or oversold area, it’s more likely, that the trend will continue.
Bullish and Bearish Divergence
Divergence is the second indicator’s function. Divergence gives a stronger reversal signal than the 30/70 levels. All you need to do is find a difference between the direction of the price chart and the indicator. When a new high of a price is not followed by a new top of the relative strength index, it’s called a bearish divergence, you got a signal to sell. That means the price will move down soon. If the price forms a lower low while the index has a low that is higher than the previous one, it’s a bullish divergence or a signal to buy.
Bitcoin RSI Chart
On the daily chart of the BTC/USD, we noticed a bullish divergence when the price formed a lower low, while the low of the RSI was higher. It was a signal of the trend reversal. Before the divergence, the price had been going down, forming a downtrend. After the divergence, we see a consolidation that was followed by the change of the trend.
How to Calculate the RSI Indicator
It’s unlikely you will need to calculate the indicator. It’s easily implemented in MetaTrader (we will explain how later). However, if you still want to measure the index, we are ready to present the formula.
The calculation consists of two parts. The first one reflects the initial Relative Strength value. It presents the ratio of the average UP closes to the average Down closes within the chosen period (N period).
RSI = 100 - (100 / 1 + RS)
Let’s take the standard period setting of 14.
- *RS or Relative Strength is Average Gain divided by Average Loss.
- Average Gain = Sum of Gains over the past 14 periods / 14.
- Average Loss = Sum of Losses over the past 14 periods / 14
Losses are counted as positive values.
The second step smooths the result:
RSI = 100 – (100 / (1 + [ previous Average Gain x 13 + current Gain] / [previous Average Loss x 13 + current Loss])
How to Implement the RSI Indicator
Now you’ve learned the basics about this indicator, and you might already want to apply it to your trading. Here, we will tell you step-by-step instruction on how to do that. Although it’s quite simple and will not take too many steps.
- Go to MetaTrader – click Insert on the upper panel – choose Indicators. You will see a list of the indicators we talked about before. You need oscillators. Click on the tab and pick up the RSI. Now, you need to set up settings.
- A period is a number of the previous bars the indicator counts. 14 is a standard setting. You can set any period and check the strength of a signal.
- The second setting is the price. It can be close, open, high, low, etc. In this case, the standard close price setting works the same as other settings.
- Other things you can do are just changing the color, the line format, and placing additional levels. 30 and 70 levels are basic. However, later you will see that some strategies require additional levels.
Relative Strength Index: Strength and Weakness
The relative strength index is one of the easiest and most accurate indicators. Nevertheless, it has not only pros but cons.
|Easiness. Despite the disadvantages, the RSI indicator is still one of the easiest indicators. It’s a standard indicator in MetaTrader. Thus, you don’t need to download or buy it.|
Additionally, it’s easy to read its signals. There are only two areas (above 70 and below 30) and one line that moves within them.
More accurate than others. There is no perfect indicator that will give a 100% correct signal to open a position. All indicators suffer a time lag just because they count the previous price movements.
Nevertheless, there are indicators with more and less accurate signals. So, the Relative Strength Index is the one that gives strong signals.
Short-term signal. Regardless of the period of the indicator and timeframe of the asset you choose, the signal of the indicator will take place for a short period.
Bonus. Useful Strategy for the Relative Strength Index
To avoid making unsubstantiated statements, we present a strategy you can use for trading with the RSI indicator.
- Currency pair – any
- Timeframe – H4
- RSI – Period 8, apply to “Close”, levels: 30, 40, 50, 60, 70
- Notice that we added more levels than usual. You can easily do that in indicator settings. When the RSI crosses the 50-level bottom-up, place a Buy Stop pending order 15 pips above the candlestick where the cross happened. Locate Stop Loss 5-10 pips below the local minimum.
- When the RSI overcomes the 60 level, place the second order. The Stop Loss should be placed 5-10 pips below the local minimum.
- The signal to close the position will appear as soon as RSI falls below the 70 level.
- When the RSI breaks the 60 level from top to bottom, place a Sell Stop pending order 15 pips below the candlestick where the cross happened. The Stop Loss should be 5-10 pips above the local high.
- When the indicator breaks below the 50 level, place another pending order below the candlestick of the cross. Remember about the Stop Loss. It will be above the local high as well.
- When the index breaks above the 30 level, close the position with your profit.
Bonus. Combine the RSI Indicator with Others
Do you remember we recommended comparing signals from at least two indicators or an indicator and a candlestick? It’s a crucial rule that will help traders keep their money.
The Relative Strength Index is similar to the Stochastic Oscillator. That’s why you can use both to get a stronger signal. Another indicator that can help you is a MACD indicator. It differs from the RSI, so that the signal could be even stronger.
Find a Trend
The RSI is used to determine a trend reversal. That’s why trend indicators will be the right addition to that. Combine signals of Moving Averages or Ichimoku Kinko Hyo with RSI.
FAQ – Something We Haven’t Told About the RSI indicator
Here, we gahered the most frequent questions you may also have.
What Is Best RSI Setting?
The only setting you should change is the period of the index. 14 period is a standard setting. However, it’s not the best one. Forex traders mostly use the 9 period for smaller timeframes and the 25 period for bigger timeframes.
H3 What Is the Best RSI Setting for Day Trading?
When trading within a day, you use small timeframes from one minute to four hours. That means the indicator should have a period not bigger than 14. 8 or 9 are the most commonly used periods. However, you are free to reduce the period as much as you want. Just remember that small periods increase the risks of fake signals.
What Is an RSI Buy Signal?
If you want to buy, wait until the index crosses the 30-level bottom-up. However, don’t buy at the break of the 30 level in the strong trend. Another buy signal may appear when the downtrend turns around. Wait for the bullish divergence (higher low of the RSI and a lower low of the price).
Now, you are ready to use this new knowledge in practice. However, don’t rush. You could become confused by the many levels and functions of the indicator we explained above. Take your time to learn how the indicator works; choose the best period setting for your strategy. We would recommend applying several RSI indicators on the chart with different settings and then seeing which signals work better. Use a Libertex demo account to practice this technique.
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