The RSI indicator also called the “Relative Strength Index” and is one of the most popular and widely used indicators in technical analysis. It is classified as relative strength because it allows us to measure how fast – how strong – the price of a security rises or falls in relation to its usual prices for a given period.
In the chart an oscillator that fluctuates in a range from 0 to 100 shows up. This signals the level of bullish or bearish force that prices show. Thus, when prices rise strongly the RSI also rises, and when prices fall the level of the RSI does so too. Like most technical indicators, the main function of the RSI is to mark buy and sell signals in order to know when to enter and exit the market. Let’s see how we can interpret these signals.
How to use the RSI oscillator
The RSI indicator signals tell a lot of information. For example, we can use the divergences of the oscillator with the price, look for “failures swings”, draw channels around the oscillator, and so on. However, the most common way to work with the RSI is to use the oscillator crosses with the overbought and oversold levels.
What does overbought and oversold mean in the RSI indicator?
As we can see in the example of chart 1, the so-called overbought or oversold zone occurs when the level of the indicator is above or below a set level. The usual levels are 30 and 70. Thus, from 30 the price is considered to be oversold, from 70 the price would be overbought
Does overbought mean expensive and oversold cheap? Yes, but relatively. When the RSI is in the overbought zone we can understand that the price is “relatively expensive” compared to the prices of the last period. Conversely for oversold, where the price is “relatively cheap.”
A trading strategy using the RSI indicator
One way to trade RSI is, for example, to use it in mean reversion systems. When we follow values we sometimes see that prices fluctuate around an average price. Sometimes stocks trade above this price, then decline, rise again, and thus move in an almost horizontal range. This volatility in the market can create attractive opportunities.
In these cases, we can use the RSI oscillator as a guide to know when we can enter the market. If we think that prices tend to revert to their mean, we expect the end of the bullish movement when the RSI is overbought. Conversely, when the RSI marks oversold then we will wait for the price to stop falling and rebound.
Thus, the strategy of these trading systems is to go long, buy when the RSI crosses the oversold level upwards and sell short when the oscillator crosses the overbought level downwards. Of course taking into account the direction of the long-term trend to always enter in favor of it. Remember: the trend is our friend. We are not trading against trend but simply taking advantage of market corrections to get a good entry point.
In this strategy we can know what the bottom trend is using moving averages of a minimum of 10 times the calculation length for our RSI.
Due to the RSI setup, it is preferable to wait for the oscillator to exit the overbought or oversold zones to enter the trade. Why? Because it may be the case in which the price continues to rise, but the oscillator cannot rise any further since its maximum value is 100. The reverse is the case of falls. The oscillator saturates when the price continues its momentum, but the RSI can no longer follow its direction.
To close the operation we will not use the RSI. As we have discussed in previous articles, each technical indicator has its utility. The RSI can indicate good entry points, but if we use it to signal exits we run the risk of closing the operation early. For this reason, to close the operation it is preferable to use a follow-up stop that allows us to make the most of the movement.
Adapt the RSI Indicator to our trading strategy
The calculation of the RSI indicator is based on the averages of the individual movements up or down in successive closing prices. The creator of this indicator, Welles Wilder, used 14 daily closing prices to calculate it. The 14 periods, together with the levels of 30 and 70 mentioned above, are what we could call the standard configuration parameters of the indicator.
Now, depending on our trading strategy, we can always calibrate the technical indicators to better match their signals with the asset and the time frame we are looking to trade (most trading platforms allow us to adjust the indicators according to our needs).
One of the parameters that we can adjust is the RSI calculation period. The shorter the calculation period, the more sensitive the oscillator is and the faster it reaches extreme levels. On the contrary, the longer the RSI calculation period, the lower the volatility of the oscillator.
In the example of graph 2, you can see the difference between a classic 14-period RSI RSI (14) and a 7-period RSI RSI (7), both applied to the same financial asset.
The other possible adjustment concerns the levels. These levels can be the classic 70 for overbought and 30 for oversold or any other level that better suits our trading strategy. For example, if we raise the levels to 80 and 20 we will have fewer signals, but in theory with greater reliability per signal.
In addition, based on the RSI, more personalized indicators such as the Stochastic RSI can be created, or use the concept of the RSI to apply it to the AD Line.