Relative Strength Index (RSI)
Welles Wilder created the Relative Strength Index (RSI), in order to identify when the market is bearing extreme situation. Knowing whether market is overselling or overbuying, an investor can make better investments.
RSI shows the important data in numbers from 0 to 100. The closer to the zero <30 means that the territory is oversold, and 70> means it’s overbought.
RSI in trading means identifying extreme situations. If the index is under 30 that means the territory is oversold. That further means that pressure of selling is high and it is likely to see technical correction. Since everybody eventually sold their assets, it means there are not many sellers, so they can raise prices up again. If the indicator turns up as well, this means a good chance to buy.
Even though the RSI identifies extremes, it doesn’t mean that a trader has to be one, and as soon as the index shows value below 30 that buying should be engaged. No extreme actions, please.
It is uncertain for how long the index can stay below 30, so other factors have to be taken into consideration. But, the indication for buying-button to be turned on is when the RSI gets above the oversold territory.
Chart shows explained situations.
Overbought territory is alerted by RSI showing value above 70. This situation means that pressure for buying is high and therefore the prices will reach their upper limits. Market is left with fewer buyers and sellers start growing their number. Just as opposite to oversold territory, when the RSI starts going down, that signals the beginning of good time to sell.
Of course, when the index reaches values above 70, it doesn’t mean that you should start selling. When it starts going down, presuming other information about the market were taken care of, selling is good to go. (Chart)
Another usage of the RSI is for confirmation of the market’s trend. A way to confirm the trend is to draw lines on the indicator that represent trend – a trend line. If the line remains steady, that means the trend holds well. These lines are very considerable to observe on larger time frames. (Chart)
RSI trend line enables earlier acknowledgment of trend changes, as the line often warns a possible breakout a bit sooner than chart trend lines.
Usage of “level 50” for additional confirming chart data about the trend means watching the RSI line moving across RSI value of 50. If it goes over 50, uptrend is in question. If it goes below 50, that marks the downtrend. This is for confirmation of chart data.
(Referring to the chart below, we insert a 50 line in the RSI indicator section (see the red line).)
Another useful usage of RSI indicator is for identifying divergence signals.
Divergence represents the situation when the RSI indicator doesn’t move according to the market’s direction. This informs us of reversing of the trend which gives us a chance of entering a trade. It is possible to identify divergence as two occurrences; bullish and bearish.
Bullish divergence will occur when a downtrend market’s prices go low further, but the indicator doesn’t go lower, but begins to go up again. This signals the change of the trend, and means a good time to buy.
Bearish divergence is the moment we see the market has uptrend, and prices are breaking high values, but the RSI stops going higher and starts going back. This signals a change of a trend, and a good time to sell.
After the RSI rise to 30, it is good to wait a bullish divergence, which is to wait for the RSI to start rising slowly while the prices had already been in a declining phase – then buy. And vice versa, when the RSI reaches 70 from higher value, bearish divergence might occur when the RSI starts to fall at the time of prices in their way up. Bearish – sell.
In short, divergence stands for change in a trend. It represents a good moment to start trading in opposite direction.