RSI Trading Strategy: Trading Indicator – Importance, How to Read and Trade Based on RSI?
The crypto space today is populated with several users who have been trading at either the beginner or intermediate level. This user base is constantly searching for strategies and patterns that can aid their investments and trading activity and steer them in a more profitable direction. While the market is flooded with such plans and tactics, it is important to choose the best, most viable options that are useful in helping you understand the most about your potential investments and as a result also facilitate you in creating an impeccable portfolio.
Trading strategies employ different and reflective indicators that serve the purpose of highlighting the metrics of a particular investment in order to indicate after a deeper understanding whether or not the investment could prove to be fruitful.
The RSI (Relative Strength Index) is a popular technical indicator used in the analysis of financial markets. It was developed by J. Welles Wilder Jr. and introduced in his 1978 book, “New Concepts in Technical Trading Systems.” The RSI indicator oscillates between zero and 100, with generally high and low levels marked at 70 and 30, respectively.
Traders and investors often use the RSI as a tool to help identify overbought or oversold conditions in the market, as well as potential trend reversals. RSI Trading strategies constitute to be one of the most powerful and popular strategies in the market. However, it can be impactful and accurate only if it is harnessed in the right way. In this article, we will explore how to use the RSI as a trading strategy and provide some tips on how to effectively implement it in your own trading.
What is Relative Strength Index (RSI)
The Relative Strength Index falls under the category of being a momentum oscillator. As briefly touched upon earlier, a momentum oscillator is a technical indicator that measures the speed and change of price movements in a financial market. It oscillates between two extreme values and is used to identify overbought or oversold conditions, as well as potential trend reversals.
Momentum oscillators are based on the idea that prices tend to move in trends, and that the momentum of a trend can be a useful predictor of its continued direction. When the momentum of a trend is strong, it is more likely to continue in the same direction. On the other hand, when the momentum is weak, it may be a sign that the trend is losing strength and could potentially reverse.
There are various types of momentum oscillators, including the Relative Strength Index (RSI), the Stochastic Oscillator, and the Moving Average Convergence Divergence (MACD). These indicators are typically plotted on a chart as a line or histogram and oscillate between two extreme values.
Now that we know the basics of what a momentum oscillator is, let’s delve deep into the details of the Relative Strenght Index. RSI works on an asset chart and compares both the bullish momentum and the bearish moments of the investment. This basically implies that the RSI indicator yields a plot that differentiates and compares how much has been gained or lost and creates a corresponding chart.
The two extremes set for the plotting of the RSI graph are between 0 to 100 respectively. This means that the lowest possible value for RSI is 0 and the lightest possible value is 100.
How the Relative Strength Index (RSI) Works
The RSI is a mathematical formula that uses price data to measure the strength of a security or currency pair. As discussed earlier, It is typically plotted on a chart as a line that oscillates between zero and 100.
How is Relative Strength Index (RSI) calculated?
The formula for the RSI is as follows:
Relative Strength Index = 100 – (100 / (1 + RS))
Where RS is the average gain of up periods divided by the average loss of down periods.
The average gain of up periods is calculated by taking the sum of all the gains during up periods and dividing it by the total number of up periods. Up periods are defined as periods in which the price of the security or currency pair closes higher than it did in the previous period.
The average loss of down periods is calculated by taking the sum of all the losses during down periods and dividing it by the total number of down periods. Down periods are basically the periods in which the price of the security or currency pair closes lower than it did in the previous period. In the formula, the average loss in taken as a positive value mathematically.
How is Relative Strength Index (RSI) plotted?
To plot the RSI on a chart, you will first need to select the security or currency pair that you want to analyze. You can then use a charting platform or software to apply the RSI indicator to the chart.
Most charting platforms will allow you to customize the settings for the RSI, such as the time frame and the number of periods used in the calculation. The default setting for the RSI is usually a 14-period time frame, but you can adjust this to suit your own preferences.
Once you have applied the RSI to the chart, it will be plotted as a line that oscillates between zero and 100. The RSI is typically plotted in a separate window below the price chart. RSI is directly proportional to the number and size of up days. This means that when up days increase, RSI rises and it falls when the number or size of down days increases. Look at this image that reflects a plot for RSI by Investopedia.com that can help you understand RSI graphs a little more.
Where to find Relative Strength Index in Trading Assets
You can find RSI graphs on various platforms.
Go to the platform of your choice, like TradingView in this case.
Now chose the desired asset and head on to the indicators section.
There you just have to simply type and select the RSI option and the RSI chart will be available for you in the lower section.
Around 80% of users use RSI with its default settings which constitute a 14-day period, the overbought level which is set at 70 and the oversold level at 30. When the RSI is above 70, it is considered overbought, indicating that the security may be due for a price correction. This means that the asset might be overvalued. On the other hand, when the RSI is below 30, it is considered oversold, indicating that the security may be undervalued and due for a price rally. This is the regular mode of RSI
Another way to use the RSI is by employing the aggressive mode which is often used by big analysts, fast traders, and those wanting to earn quick money. In the aggressive method, we need to alter the setting slightly which is normally used in intraday trading or scalping etc. in this scenario you will have to change the period from 14 to 2. The overbought level will be changed to 90 instead of 70 and the oversold level will be altered to 10 instead of 30. The permissible time frames that can be used in this case are 5 minutes, 10 minutes or at max 15 minutes.
RSI Trading Strategies
There are several strategies that traders can use when implementing the RSI into their trading. Here are a few examples:
As mentioned earlier, one common way to use the RSI is to look for overbought or oversold conditions in the market. This is one of the most popular and viable techniques to use RSI Trading Strategy. When the RSI is above 70, traders can look for sell opportunities, and when it is below 30, they can look for buy opportunities. Let’s elaborate on this now
Traders and analysts keep a keen eye on these overbought and oversold trends. In a scenario where RSI exceeds 70 and indicates an overbought asset, we can say in simple terms that traders notice the high volume or overvalued nature of the asset and decide to start selling it. On the other hand, when the levels drop to or below the 30 mark, traders see that the asset has been sold a lot and they start to buy it more and open a buying or long position.
Traders can also use the RSI to look for divergences between the indicator and the price action of the security. A bullish divergence can be a sign of a potential bullish reversal, while a bearish divergence can be a sign of a potential bearish reversal.
RSI Failure Swings Strategy
RSI failure swing is a technical pattern that can occur when the RSI moves out of an overbought or oversold level and then subsequently fails to reach a new high or low. This pattern can be a sign of a potential trend reversal.
To identify an RSI failure swing, traders should look for the following sequence of events:
- The RSI moves above 70 (overbought) or below 30 (oversold).
- The RSI then forms a lower high or higher low.
- The RSI subsequently moves back into the overbought/oversold level and breaks through the previous high or low.
- If this pattern occurs, it can be a sign of a potential trend reversal. Traders can use this information to enter trades in the direction of the reversal.
Another way to use the RSI is to follow trends. When the RSI is above 50, it can be a sign of an uptrend, and when it is below 50, it can be a sign of a downtrend. Traders can use this information to either buy into an uptrend or sell into a downtrend.
How to use and implement different RSI Trading strategies.
One mistake that a lot of users make is that when RSI reach the 70 and 30 mark, they start selling or buying immediately. The 70 and 30 positions are where most users get stuck. At the 70 zones, people get stuck because the graph doesn’t come down and keeps increasing and on the contrary people face an issue at the 30 levels when the graph doesn’t increase and only drops further. This happens because when users gain entry, they do so without calculating the right aspects and also at an incorrect level. Hence it is important to learn when to take entry.
This goes to explain that as a user you need to use all three RSI techniques of Overbought/Oversold Strategy, Divergence Strategy, and RSI Failure Swings Strategy to be able to make profitable decisions. Look at the following points and criteria that will give you a brief overview and understanding of how you can use RSI correctly to take an entry in a successful manner.
The first criterion is to fall under the overbought or oversold zone. After this you will have to find the bullish divergence or the bearish divergence, depending on whether you are on the oversold or overbought side respectively. The final criterion to figure out is termed as break out. People often fail because they focus only on the first criterion and neglect the remaining two.
What is divergence in RSI?
In technical analysis, divergence refers to a situation where the price of an asset and an indicator such as the Relative Strength Index (RSI) are moving in opposite directions. Divergence can signal a potential trend reversal and can be used to identify buying and selling opportunities.
How to figure out bullish divergence?
Let’s first figure out bullish divergence. Let’s assume we have the price chart for an asset. The RSI keeps dropping and creating consecutive lower lows. Simultaneously we look at the RSI graph. The plot drops and falls below the 30 levels, making a Lower Low. After this, the price increases a little (while staying under 30). Finally, it creates a Higher Low, drops again but not as much as the previous lower low and rises to break the 30 mark. In such a scenario where there is a lower low and higher low in RSI while the price chart shows Lower Lows, it indicates a bullish divergence. This can be a sign that the asset is about to experience a bullish reversal, as the RSI is showing strength while the price is showing weakness. A bullish divergence will reflect that in some time, the price is likely to break out and increase. In this scenario, you can use stop-loss orders and Consider taking a long position while keeping other factors in mind.
How to figure out bearish divergence?
Now we need to understand the concept of a bearish divergence. bearish divergence is a pattern that occurs when the price of an asset is making higher highs while a momentum indicator, which is the Relative Strength Index (RSI) in this case, is making lower highs. This in a way indicates that the asset is probably about to experience a bearish reversal, as the RSI is showing weakness while the price is showing strength. In order to confirm a bearish divergence, it’s important to wait for the indicator to move below the overbought level (above 70) or to see a trend line break or a price breakdown to confirm the signal before entering a trade. In case of a bearish divergence, traders may consider taking a short position in the asset or set a stop loss order to minimize potential losses in case the market moves against them. Traders also must monitor other indicators, price actions and market conditions, and use multiple confirmations before entering a trade.
When to take entry during breakout
When using the Relative Strength Index (RSI) in conjunction with a breakout strategy, traders typically look to enter trades when the RSI confirms a breakout of a key level of resistance or support. This works along with the RSI Failure Swings Strategy
How to determine Bullish Breakout
In a bullish breakout, the following things will happen
- RSI will drop, cross 30 and create a dip
- RSI will then increase crossing the 30 level after which it will drop again but will now go below 30 this time
- Then RSI will increase again and then create another dip. The level to which this increase occurred is termed the breakout level.
- After the dip when the RSI level rises again and crosses the breakout level, that indicates your entry point for a long position.
How to determine Bearish Breakout
In a bearish breakout, the following things will happen
- RSI increases and crosses 70 to reach a peak
- RSI will then fall, surpass the 70 level and will again increase creating a dip. However, this increase will not cross 70
- Then RSI will fall again, creating another dip. The level to which this drop occurred is the breakout level.
- After the dip when the RSI level falls again and crosses the breakout level, that indicates your entry point for a short position.
Tips for Using the RSI Trading Strategy Successfully
Here are a few tips for effectively implementing the RSI trading strategy:
Use Multiple Time Frames: It is important to consider the RSI on multiple time frames when trading. This can help you get a better overall picture of the market and make more informed trading decisions.
Don’t Rely Solely on the RSI: While the RSI can be a useful tool, it is important to remember that it is just one indicator among many. It is important to use the RSI in conjunction with other technical and fundamental analysis tools to get a more complete picture of the market.
Use Confirmation Signals: It is always a good idea to use confirmation signals when trading. For example, if you see a bullish divergence on the RSI, you might wait for a price breakout or a trendline break to confirm the signal before entering a trade.
Use Stop Losses: As with any trading strategy, it is important to use stop losses to protect your capital. This can help you minimize potential losses if the market moves against you.
Consider Using Other Indicators: While the RSI can be a powerful indicator on its own, it can also be useful to consider other technical indicators when making trading decisions. Some popular indicators to use in conjunction with the RSI include the Moving Average, the Stochastic Oscillator, and the MACD.
What are the Limitations of RSI?
The Relative Strength Index (RSI) is a widely used technical indicator, but it has its limitations. One limitation is that it can generate false signals, especially in range-bound markets where the RSI can oscillate between overbought and oversold without indicating a trend. Additionally, RSI is a momentum indicator and works best in trending markets, in non-trending markets, it may fail to signal tops and bottoms as compared to other leading indicators. RSI is also limited to price moves and doesn’t take into account volume or other market factors, which can provide a more complete picture of market conditions. Additionally, the traditional levels of overbought and oversold are 70 and 30 respectively, but these levels can vary depending on the market and instrument being analyzed. Therefore, traders should use RSI in conjunction with other technical indicators and market analysis to get a more complete picture of market conditions.
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To sum up
In conclusion, RSI trading can be a valuable tool for traders looking to gain an edge in the markets. By analyzing the relative strength of an asset, RSI can help traders identify overbought and oversold conditions, which can provide valuable information about when to enter or exit a trade. However, it’s important to remember that RSI is just one indicator and should not be used in isolation. Relative Strength Index must be used along with other mechanisms and techniques. By doing so you will gain a more comprehensive understanding of the position of an asset and your financial endeavours will prove to be a lot more profitable. Keep in mind that RSI is a reactive indicator, meaning that it gives signals after the trend has started, and not before, which is why it’s crucial to have a well-defined strategy that makes use of multiple indicators to have a better view of the market. Additionally, it’s crucial for a trader to have a well-defined strategy in place and they should always be sure to use proper risk management techniques to protect themselves from losses.