What is the RSI?
The Relative Strength Index (RSI) is a popular technical indicator used by traders to measure the strength of a market trend. It’s a momentum oscillator that compares the magnitude of recent gains to recent losses to determine overbought and oversold conditions of an asset. In this article, we’ll discuss the basics of how to use the RSI indicator effectively; including how it’s calculated, the best settings to use, and how to spot divergences.
RSI calculations and settings
The RSI is calculated by taking the average of the gains and losses over a certain number of periods. The default setting for the RSI indicator is 14 periods, but this can be adjusted to your preference. Some traders prefer to use a shorter period for the settings, such as 5 or 9, in order to get a more sensitive reading of the market. Others prefer to use a longer period, such as 25 or 50, in order to get a more stable reading over the market and minimize false signals.
To figure out what works best for you, just change the settings on your preferred timeframe and do some backtesting to see what the results would have been. I personally like to keep my RSI settings to the default 14 as that’s what most traders are looking at.
Overbought and oversold conditions
The RSI ranges from 0-100. It’s commonly taught that when the RSI hits 70 or above, the market is overbought, and if the RSI heads down to 30 and below, the market is oversold.
Keep in mind though that the RSI can remain in overbought and oversold territory for quite some time. If you long and short based on those metrics alone, you might get yourself in trouble – especially if you’re trading with leverage.
Instead, as with pretty much all the indicators profiled on this site, you want to use them in combination with each other, as well as the price action.
For example, did the RSI hit an oversold level right as you approached an established resistance level? Or, did it hit an oversold level after broke through an established resistance level? It it just broke through an established long term resistance, the price could run up higher than you’d expect, so be careful.
RSI bullish and bearish divergences
I mainly use the RSI as a tool to spot divergences. A divergence occurs when the RSI indicator moves in the opposite direction of the price. There are four types of divergences: bullish, bearish, hidden bearish, and hidden bullish.
A bullish divergence occurs when the price is making lower lows while the RSI is making higher lows. A bearish divergence occurs when the price is making higher highs while the RSI is making lower highs. A hidden bearish divergence occurs when the price is making higher lows while the RSI is making lower lows, and a hidden bullish divergence occurs when the price is making lower highs while the RSI is making higher highs.
Remember, the RSI is a momentum oscillator, and these divergences will show you if the momentum is strengthening or weakening.
Is the price flirting with a resistance level and you want to know if it’s likely to break down so you can short? Pull up the RSI and look for a bearish divergence. If you see one, that tells you that the “bulls” are running out of steam.
The same is true at support levels. See a bullish divergence? That means the momentum to the downside is weakening and the “bears” are losing strength.
I never trade on divergences alone. I always use them in conjunction with price action (support and resistance levels), as I suggest you do the same.
In case you’re wondering, I’m not using the standard RSI. Rather, it’s called the “divergence indicator”, and it’s available on the TradingView platform. It’s essentially an RSI that labels the divergences for you in real time. It shows you standard bullish and bearish divergences by default, but you’ll have to go into the settings and check the boxes if you want to be shown the hidden divergences as well.
RSI trendlines
Like the price, you the RSI will sometimes adhere to trendlines. Here’s an example of a 2 year RSI trendline that was just broken on the weekly BTC chart..
Watch for these trendline breaks to add confluence to your buys and sells.
Cross Ups and Cross downs
Simply selling when the RSI hits 70 or above, and buying when it hits 30 or below can get you in trouble for the reason mentioned above – it can stay in those ranges for a long time and go a lot higher or lower.
What you can do to increase the strength of the signal is to watch for when the RSI goes goes into oversold territory, then look to enter as the RSI crosses back up above the 30 level. Likewise, look to short when the RSI crosses back down below 70 after entering the overbought territory.
The 50 level
The significance of the 50 level on the RSI indicator is that it is considered to be the neutral level. When the RSI is above 50, it is considered to be in bullish territory, and when it is below 50, it is considered to be in bearish territory.
Summary
The RSI is a great indicator that can be used to measure the strength of a market trend, to spot divergences, and to confirm trading signals. Like any indicator, you’ll get the best results by using it in combination with your price action analysis. Use it for confluence/conformation rather than standalone signals.
