An Introduction to Relative Strength Index Trading Strategies | Hacker Noon

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@leah-mathiesonLeah Mathieson

Writing about law, Wall Street, VC & startups. Echelon-1.com

Relative Strength Index (RSI) is another staple indicator of the technical analysis world. What is the Relative Strength Index?  It measures the speed and change of price movements to evaluate if a stock is overbought or oversold. A wildly popular tool among traders, it is also widely misunderstood.

Momentum can be a strong predictor of market direction where it is correctly applied. However, many traders don’t bother to learn the intricacies of RSI and then get stuck in bad positions by underestimating how long a stock can stay overbought or oversold. 

We’ll take you through the proper interpretation of RSI, how it’s calculated and the different ways to use it to better inform your trading.

What is the Relative Strength Index (RSI)?

Relative Strength Index (RSI) is a momentum indicator.  What is a momentum indicator?  It measures how well a stock is performing against itself by comparing the strength of price, speed, and magnitude of recent price changes. From this, RSI can evaluate overbought and oversold market conditions. If a stock is trading above its true value, it is considered overbought. If a stock is trading below its true value, it is considered oversold. RSI can also be used to reveal price trends and suggest points to enter and exit trades. 

Relative Strength Index (RSI) is also an oscillator. What is an oscillator?  Oscillators are indicators that are used when viewing charts that are ranging (non-trending) to determine overbought or oversold conditions.  Its value is displayed as a number from 0-100. The traditional interpretation of the RSI sees the areas below 30% and above 70% as significant territories. Where the RSI is greater than 70%, this indicates that the stock is overbought or overvalued. This suggests that the stock is primed for a corrective pullback. Where the RSI is lower than 30%, this shows that the stock and oversold or undervalued, suggesting that the stock may be due for a reversal.

How do you calculate RSI?

It’s highly unlikely that you will ever need to calculate RSI manually. Most popular trading platforms and charting interfaces will have the indicator available as a tool. But like most technical analysis functions, using RSI is pointless if you don’t understand how the value is computed and what it actually tells you.

Developed in 1978 by J. Welles Wilder, a mechanical engineer turned technical analyst, RSI involves a two-part calculation. 

The first part computes the initial Relative Strength value. This is the ratio of the average of ‘up’ closes to the average of ‘down’ closes of an underlying stock, within a chosen period. The default chosen period suggested by J.Wilder is 14 days. Although other popular time periods are 9 and 25 days. The period is adaptable and can be changed to suit your trading style – more on this later. While a shorter period RSI is more reactive to recent price changes, it is also more sensitive to false readings. 

The second part of the calculation smoothes out and indexes the Relative Strength value so that it is presented as a number from 0-100. 

On charting interfaces, the RSI will be plotted beneath the stock chart. You will notice that as the number and size of ‘up’ closes increases, so too will the RSI. As the number and size of ‘down’ closes rise, the RSI will fall. 

How to Use RSI?

With just a basic understanding of RSI, many traders tend to do the following:

  1. Enter into long positions when RSI nears 30, because they’re expecting the stock to shoot up.
  2. Sell or short positions when RSI nears 70, because they’re expecting a corrective pullback.

Very rarely is trading this simple!

Traders often overlook the fact that RSI can stay in the extreme overbought and oversold territories for extended periods of time. This especially occurs while a stock is trending. 

Like many momentum oscillators, RSI works best and is most reliable when prices move in a trading range. During trending markets, RSI is more prone to give off misleading signals. To validate predictions and get a more complete picture of the market, RSI should always be combined with chart analysis or other technical indicators. Only looking at RSI while ignoring other market conditions is a surefire way to blow up your account. 

RSI can be a powerful tool. But it is not the be-all and end-all of technical analysis. You still need to put in the work. Observe the market. Get to know the stock. Take notice of how price moves and experiment with time periods and RSI levels. For example, if you’re scalping you may need a more sensitive RSI than the standard 14 period. Instead, you may choose to lower the time period to 9. If you’re dealing with a volatile stock, you might find that 20/80 levels are more accurate than the traditional 30/70. Experiment, observe, test, and learn.

We delve into the different trading strategies that use the Relative Strength Index below. 

Centerline Crossovers

More than just an overbought/oversold indicator, RSI can also reveal price trends. 

Generally speaking, the 40-90 RSI zone signifies the bull market range. While the 10-60 RSI zone acts as the bear market range. While there is some overlap, 50% is typically seen as the midline that separates these two territories. When the RSI value crosses over this 50 midline, it can be interpreted as signaling a new market trend. 

There are two types of crossovers:

  • Rising Centreline Crossover – RSI moves from below 50 and nears 70, signaling a bullish trend. 
  • Falling Centreline Crossover – RSI moves from above 50 and nears 30, signaling a bearish trend. 

RSI Trendlines

Another strategy that signals price breaks is the RSI Trendline. A break in an RSI trendline usually precedes the break in a price chart trendline. This can act as an early signal of a potential price reversal, giving you an early opportunity to enter or exit a trade. 

An RSI upward trendline can be drawn by connecting three or more of the highest peaks on an RSI line as it rises. For downward trendlines, connect three or more of the lowest points on an RSI line.

RSI Two Period Divergence

This strategy uses two RSI periods, one longer-term (RSI 14) and one shorter (RSI 5). Oftentimes the market will change direction before the RSI even reaches oversold/overbought territory. A shorter period RSI reacts faster to recent price changes, so it can help reveal these early signs of reversals. By looking for where the shorter RSI crosses over the longer RSI, this could signal buy and sell opportunities. It is a simple and effective strategy that is often used in conjunction with Pivot Points. 

  • Buy Signal – When the shorter-term RSI crosses above the longer-term, this indicates that recent prices are increasing and is a potential buy signal.
  • Sell/Short Signal – When the shorter-term RSI crosses below the longer-term, this indicates that recent prices are falling and is a potential sell or short signal.

Classic Divergence 

This strategy helps identify divergences that can act as advance warnings of reversals. This happens where an RSI reading does not match the stock’s price movements. Divergences signal a potential reversal point because directional momentum does not confirm with the price. There are two types of divergences, bullish or positive divergence and bearish or negative divergence. 

Bullish Divergence

A bullish divergence occurs when the RSI produces an oversold reading that is followed by a higher low. While the stock price forms a lower low. 

When this happens, traders can interpret this as a sign that selling momentum is slowing down and the price will likely rise. 

Looking out for Bullish Divergence can help trigger new long positions. But be mindful that RSI can be misleading during strong trends. Numerous divergences may appear during a strong downward trend before the bottom even materializes. 

Bearish Divergence

Conversely, a Bearish Divergence occurs when a stock price reaches a higher high but the RSI forms a lower high. Traders can interpret this as a sign buying momentum is slowing and the price will likely fall.

Bearish divergence can trigger sell or short signals. But remember, there may be numerous bearish divergences in a strong upward trend before the predicted pullback occurs. 

RSI Swing Rejections

RSI Swing Rejections focus solely on RSI behaviour and ignores price action. By looking at how RSI behaves after it emerges from overbought and oversold territories, it can be seen as an incredibly strong predictor of an impending market reversal. Like classic divergences, there is a bullish and bearish version of RSI swing rejections. Both versions appear as mirror images of each other. We discuss how to identify bullish and bearish swing rejections below. 

Bullish Swing Rejection

A bullish swing rejection or a Failure Swing Bottom happens when stock price makes a lower low but the RSI makes a higher low and rises above the most recent high point. This indicates bullish momentum and is seen as a buy signal.

A Bullish Swing Rejection has the following trajectory.

  1. RSI moves below 30 into oversold territory
  2. RSI bounces back above 30
  3. RSI pulls back but holds above 30
  4. RSI then breaks out and breaks its most recent high
  5. Indicates bullish momentum and buy signal triggered

Bearish Swing Rejection

The mirror image of the bullish swing rejection is the bearish swing rejection or a Failure Swing Top.  This occurs when stock price makes a  higher high but the RSI makes a lower high and falls below the most recent low point. This indicates bearish momentum and is seen as a sell signal.

A Bearish Swing Rejection has the following trajectory.

  1. RSI rises above 70 into overbought territory
  2. RSI pulls back below 70
  3. RSI bounces back up but fails to exceed 70
  4. RSI then breaks down and breaks its most recent low 
  5. Indicates bearish momentum and sell signal triggered

Although swing rejections ignore price action, they are most reliable when they align with the predominant long-term trend in the stock price. For example, a bullish swing rejection in an upward trend will be more reliable than a bearish swing-rejection in an upward trend.

Failure swings are used as signs of a trend reversal. Traders will then use these signals to enter or exit positions when verified by looking at other indicators.

Is it better to use RSI or MACD?

The moving average convergence divergence (MACD) is another momentum technical indicator. Where RSI measures momentum by showing whether an underlying stock is overbought or oversold,  MACD measures the relationship between two exponential moving averages to show momentum.

The MACD line is formed by subtracting the 26 period EMA from the 12 period EMA.

Despite RSI and MACD both being momentum indicators, you don’t necessarily need to decide to use one instead of the other. Since they both use different factors to measure momentum, they can work alongside each other to provide a more holistic technical view of the market.

Test. Observe. Learn.

Remember, when it comes to choosing the right indicators to build your trading strategy, it all comes down to experimenting. You need to put in the time to experiment, test, backtest, observe and learn.

RSI can be a strong signal for market momentum. However, RSI was designed to be a support indicator, not the main instrument. Experiment with RSI and a combination of trend indicators or at least pay close attention to price action to better inform your trading strategy.

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