The RSI is one of the most well known and used technical indicators today, and was introduced in the 1978 book “New Concepts in Technical Trading Systems” by J.Welles Wilder. In this article, we will take a closer look at how the RSI works, for what it can be used, and how we should use it!
What is The Relative Strenght index (RSI)?
The RSI indicator is a momentum oscillator that is used to measure the speed and change of price movements. The RSI moves between zero and 100, and by reading its value traders or investors can get a clue about whether a security is overbought or oversold. Normally, an RSI level of over 70 is considered overbought, and an RSI level of less than 30 is considered oversold. The Relative Strenght Index can also be used to identify the general trend, or find divergences that could predict an imminent turning point in price.
How Is It Calculated?
The RSI indicator works by comparing two different measurements.
- The first measurement is price gains on up days. Up days are defined as days closing higher than the previous day’s close.
- The second is price losses on down days. Down days are defined as days closing lower than the previous day’s close.
The RSI compares the relative strength of these two measurements and is calculated as follows:
RSI= 100- [100/1 + RS]
RS is the average of all positive changes within the look-back period, divided by the average of all negative closing changes.
Overbought And Oversold Conditions
When traders use the RSI indicator in their trading, they usually apply it to price to find oversold and overbought conditions. When investors refer to overbought and oversold securities, what they mean, is that the price has moved excessively in one direction, and most likely is soon to revert to its mean. This type of trading often is referred to as Mean Reversion.
In mean reversion, we utilize the tendency of some markets to produce exaggerated price movements that correct themselves shortly thereafter. Securities never go straight from point A to point B for extended periods. Instead, most securities that trend upwards make an upward movement, retract a little, and continue in the direction of the trend. With the help of the RSI, we can identify when the price has gone up or down too much – in other words when it’s oversold or overbought – and is likely to retract a little. In mean reversion trading, it’s this retraction that we profit from.
In the picture above, you can see the RSI indicator applied to a price chart. The purple area covers all RSI readings between 30-70. As you see, when the RSI crosses over 70, it’s an indication that we will soon see a pullback . Conversely, if the RSI crosses under 30, it’s an indication that the price of the security is soon to rise!
Other Ways of Applying The Relative Strenght Index
The most widely known trading method involving the Relative Strenght Index is the mean reversion type. However, the RSI can be used in a variety of ways, depending on the characteristics of the market we’re working with. Some markets are of the type that trend a lot, and others move more indecisively, which makes it hard to point out the direction of the trend. Depending on what market we work with, we need to adjust our approach. For example, a mean-reverting approach might work well on indexes and stocks, but not as well on energy markets that tend to trend more. Here follow some different methods of applying the RSI indicator:
1. RSI Breakouts
While the most common application of the RSI indicator is to identify stocks or other securities are about to turn around, you could also use the RSI enter trades on pure strength. In some markets or particular circumstances, a high RSI reading could be a sign of overall strength in a price movement. In that case, the concept of overbought and oversold levels doesn’t apply, since the high RSI reading becomes an indication that the price movement isn’t finished just yet considering all the momentum.
As you can see in the example, the RSI indicator crosses under 30 and price continued down after that. This type of strategy works best in markets that tend to trend, and not so well in mean reverting markets such as equities in general.
There are two main types RSI divergences; Bullish divergences and bearish divergences. A bullish divergence is when an overbought RSI reading is followed by a lower one, while the security is making new highs.
A bearish divergence is when an oversold RSI reading is followed by a higher reading, while price simultaneously is making new lows.
In the picture you can see how the security is making new lows, while the RSI indicator has begun to tilt upward. This an indication that the strength of the movement is abating, and that a turnaround could be imminent.
3. Swing Rejections
Swing rejections is a trading technique that waits to see what happens after the RSI reemerges from oversold or overbought levels. The added criteria become a sort of confirmation that makes sure that we don’t enter a trade before the RSI indicator has commenced its reversion back to the mean. However, higher accuracy comes at the cost of lower average trade, since much of the movement will already have been made once you enter.
A bullish swing rejection would be that the RSI indicator falls below 30%, crosses back above 30, makes a new dip without going under 30%, and then breaks the recent high.
In the example above we see a successful bullish swing rejection. RSI closes below 30, makes a new higher low, and breaks the recent high. Of course, there is a bearish version of this pattern as well, which simply is an inverted bullish swing rejection.
4. Support and Resistance
With traditional technical analysis, support and resistance levels play a significant role. However, price levels are such as the previous high or lowest low are not the only markers that could act as support and resistance lines. The Output of the RSI indicator could as well be used to determine support and resistance levels. Have a look at the picture below, where we have plotted some support and resistance levels in the RSI indicator.
5. Double bottom signal
The double bottom signal is a common one that you can find in traditional technical analysis. As with the resistance and support levels, it can be applied to the output of the RSI as well.
In the picture above you can see how a double bottom in the RSI preceded a short burst of upwards movement.
What can be tricky with these types of signals, is that they’re difficult to identify at an early stage. Once you have found that the last part of the setup is in place, most of the price movement could already have occurred!
What Is Connors RSI?
Connors RSI was developed by Larry O’Connor and is largely based on the base Relative Strenght Index indicator. However, it holds some differences. Connors RSI is calculated by taking the average of three factors:
The RSI Value
This value is taken from the base RSI indicator.
The Length of the Down/up Streaks
The length of an up streak is defined as how many days in row s a stock closes at a higher price than the day before. Conversely, the length of the down streak is defined as how many bars in a row a stock closes lower than the bar before.
The Rate of Change
The rate of change is calculated on the most recent price action and is output as a percentile
What are the Best RSI Settings?
The most common settings of the RSI indicator is a 14-days lookback period with the oversold threshold set at 30 and the overbought threshold set at 70. However, the RSI can be tweaked, and the inputs can be changed to work better with the specific market you’re working with. Sometimes, different trading styles might require different RSI settings. We encourage everyone to experiment to see what seems to work the best. If a 10 day lookback period consistently appears to be better than the default 14-day, there is no need to stick with it!
However, there some more general guidelines that you should consider:
- In a market that trends upwards, it could be useful to adjust the RSI threshold values to make them a little higher. What can be said generally about rising markets is that they tend to not recede as much as flat or falling markets before they make the next great swing. In such a scenario, with too low RSI threshold values you run the risk of getting very few trading signals
- Conversely, when in a falling market, it could be beneficial to adjust down your threshold values. Falling markets tend to fall for longer periods of time before there is a pullback. You should make sure to reflect this in your parameter settings.
The RSI2 Strategy
Some of you might have heard about a common and widespread strategy that uses the RSI indicator with a 2 days period lookback. The RSI2 strategy has worked well for many years and is a short term mean-reverting strategy. The rules for this strategy are as follows, even if the parameter settings are not set in stone:
If RSI crosses below 10, then buy.
If RSI crosses over 50, then sell.
We wouldn’t recommend you to trade this strategy as is, but it could be a good start on an RSI trading system!
Final Tips on Using RSI in Your Trading
Beginning traders are often very focused on what indicator they should use and what parameter settings they should use. The truth is that trading success is very little dependant on which indicator you use. The Relative Strenght Index, like all other indicators, should be seen as one of many tools that are at your disposal.
Nonetheless, The RSI is an excellent indicator that we at the Robust Trader use a lot! Use it wisely, and it will be of great value to you as well!