In 1978 J. Welles Wilder developed the RSI indicator and introduced it in his seminal book, New Concept in Technical Trading Systems.
The basic concept of the RSI is that it has two main values:
- 70 or above indicates that the market is being overbought.
- 30 or below indicates that the market is being oversold.
The Relative Strength Index, abbreviated RSI, is a momentum-based indicator. RSI is used to measure the velocity as well as market fluctuations to value overbought or oversold condition on Forex pairs, cryptocurrencies, stocks or any type of assets.
The market is considered overbought when the RSI evolve above 70 and oversold when the RSI is below 30.
See the chart below, when the RSI reached the overbought zone, the price action retraced and made a pullback from the top. When the RSI reached the oversold zone, the market reversed from the bottom.
In a strong trend, RSI loses its accuracy which leads to misleading overbought or oversold conditions. Market price can remain overbought or oversold for a long period without reversing. In this case, the RSI sticks in the overvalued or devalued zone for a long period and consequently generate many wrong buy/sell signals.
So when the trend is strong, you should not buy at oversold or sell at overbought zone. The chart above shows that the RSI provided several false buy signals.
In a ranging market, the RSI indicator provides a sell signal when its chart gets above the 70 line.
When the RSI gets back to the oversold zone, you should close your sell position. It’s important to note that we are in a ranging environment, so price may reverse when it reaches the lower range.
In a ranging market, the RSI indicator provides a buy signal when its chart moves below the 30 line.
When it rises to the overbought zone, you should close your long positions as market may reverse. See the chart above market always bounced from the oversold zone.
A bullish divergence pattern occurs when the market creates a lower low but the RSI makes a higher low. When the RSI does not reflect market lows, this is a sign of market consolidation and consequently, a reversal may occur.
See the chart above, the RSI makes a bullish divergence which is followed by a rise in price action.
A bearish divergence pattern occurs when the market creates higher highs but the RSI makes lower highs. When the RSI indicator gives a divergence signal at the overbought zone, the bullish momentum may stop and market reverses.
On the chart above, when the market did higher highs, the RSI formed lower highs, then price dropped from its highs. In this particular case, as we are in an uptrend, it’s better to take profit when the RSI touches the 30 level again.
A bullish divergence can occur in a strong downtrend, and yet the market continues to fall. Sometimes divergence creates false signals. In a strong downtrend, the RSI will form bullish divergence but price will not change its direction. So in a strong downtrend, you should ignore the bullish divergence pattern.
On the chart above, the price action is falling steadily even though the RSI gave us a bullish divergence pattern.
In a strong uptrend, you may see several bearish divergences but the market still goes up.
You can see this phenomenon is the chart above as in several times, the RSI has created a bearish divergence, but the price action has not changed its direction. In this particular case, a major news release maintained the bullish momentum. In a strong uptrend, you should NOT use the bearish divergence pattern for entry.
Constance Brown suggests that the RSI oscillator tend to move most of the time between 40 and 90 in an uptrend market, with the 40/50 zone acting as support.
On the chart above, we have set a 14 period RSI on a bullish market. The 40/50 zone acts as support. So in an uptrend market, anytime the RSI goes into the 40/50 zone, it gives buying opportunities with the prevailing trend. When in an uptrend, the RSI can’t break 40/50 zone, we will consider it support and will go for a long position in the 40/50 area.
The RSI tends to oscillate most of the time stuck between 10 and 60 in the bearish market. With the 50/60 zone acting as resistance. When the 70 line can barely be touched for a long time, it indicated a bear market. So in a downtrend market, it’s a good idea to go short in the 50/60 RSI resistance.
On the NZD/USD chart above, the 50/60 zone acted as resistance and the RSI dropped to near 10. In the strong downtrend market, you should treat the 50/60 zone as resistance and go short form it.
Wilder used the 14 RSI. There are others that use RSI with different periods. The 14 period is set by default on trading platforms. You may change it based on your trading strategy. To change the period of the RSI, double-click on the chart of the indicator from your Metatrader platform. Then click on the input tab and change the value to the period you want to use.
The RSI can be a good indicator to trade with the trend:
- Spot the primary trend of the market.
- Trade only in the direction of the overall trend.
- If the trend is up, buy the dips.
- If the trend is down, sell in rallies.
See the chart above, the market is on a clear uptrend, so we also drew a trendline. As long as the trend line does not break, you can combine it with the RSI to trade with the trend.
So in the bullish market, buy when the RSI retraces to the 50/30 zone as long as the trend line holds. You may place your stop loss just below the trendline.
On the other hand, if the market is bearish, sell when the RSI retrace to the 50/70 zone as long as the bearish trend line is still valid. You may place your stop loss just above the trendline.
To determine your take profit level, we recommend using at least a risk-reward ratio of 1:2.
RSI is one of the main indicators in technical analysis. It can help you find out trading opportunities. Combining RSI with trendline can give a perfect trade if you can hold your position long enough to allow it to develop. The RSI indicator can make your trading strategy more profitable if you can use it with the prevailing market trend and be patient.