The Relative Strength Index (RSI) is a versatile tool in market analysis, enabling traders to identify potential buy or sell signals. Here are five ways to utilize RSI:
- Overbought/Oversold Levels: Use RSI readings above 70 to indicate overbought conditions and below 30 for oversold conditions, signaling potential reversal points.
- Divergence: Watch for discrepancies where the RSI trends oppositely to price, suggesting a potential price reversal.
- Trend Confirmation: RSI can confirm the strength of a trend; an RSI above 50 generally indicates an upward trend, below 50 a downward.
- Failure Swings: These are identified when RSI reaches a new high or low without a corresponding new price high or low, indicating a potential turning point.
- RSI and MA Cross: Combine RSI with a moving average; a crossover of RSI over a moving average can suggest entry or exit points.
Timing Buy and Sell Signals with RSI
The Relative Strength Index is one of the most popular instruments used by traders to approximate market momentum and possible reversal. Defined by J. Welles Wilder Jr., the RSI calculates the speed and price change intensity on a scale between 0 and 100. Simply put, RSI above 70 is considered overbought, and below 30 – if the asset is oversold, then traders may anticipate a reversal in price and act accordingly. To illustrate, the RSI helps decide when to buy or sell in different market conditions.
For example, when a stock is in a downtrend for an extended period, the RSI displaying 70 suggests that the stock is overbought . This means that the time may be appropriate for a price correction. Conversely, in an uptrend, if the RSI drops below 30, the stock may be oversold but can also indicate that it is a good opportunity to buy.
Moreover, traders often rely on a more sophisticated interpretation of the RSI. What is called ‘divergence’ happens when an asset’s price forms a new high or low, but the RSI does not. Eventually, this signals anything but the continuation of a trend and suggests it may be weakening. For example, the price of a stock may form a new high or low, but the RSI does not form a new high or low, creating bearish divergence, which means the stock is likely to be a sell . Additionally, an alternative known as the ‘bullish’ one signals a potential buy instead.
Lastly, RSI can be successfully combined with other analytical tools such as MACD or Bollinger Bands to ensure traders increase their precision and gather more relevant information. The latter can help approximate the channel of the asset’s price change, while the former may verify the signals derived from the main tool.
Identifying Trend Reversals
The Relative Strength Index might be useful not only for identifying overbought or oversold levels but also for trend reversals. The most prevalent tactic here is tracking the RSI for divergence – a situation when the prices and RSI movements do not coincide. In other words, the price might be showing an uptrend, but the RSI demonstrates the decrease in momentum behind the movement. For example, if a company’s stock keeps forming higher highs in the price series, yet the RSI is gathering lower highs, it implies that the price might not have the support of strong bullish movement . Such a bearish divergence might be followed by the price’s reversal downward.
Conversely, the price might move downward and form lower lows, but the RSI would form higher lows, indicating dying momentum for bears. As a result, the bullish divergence in RSI might be the signal for the trend reversal upwards.
To properly employ the RSI for identifying trend reversals, the following steps need to be taken by the traders:
-
The RSI needs to be watched closely during the formation of trends in prices.
-
If the conditions of divergence are met, one would need to confirm the trend’s reversal by making sure the RSI has already moved above or below the crucial 30 and 70 support levels. Namely, if the bearish divergence is identified in RSI, one should enter a sell trade only after confirming the signal.
-
The signal can also be verified using the volume analysis or tracking the moving average.
For example, a trader might follow the bearish divergence until the price indeed moves in the opposite direction, and a 50-day moving average suggests a strong tendency of price to start a new trend downwards. As a result, this combination of indicators increases the signals’ reliability and allows the trade to enter the market in the right position.
Filtering Signals to Reduce False Alarms
One of the drawbacks of the RSI is the difficulty of distinguishing real trading signals from certain false alarms. As such, many traders and analysts combine the use of RSI with other indicators that are supposed to filter the noise and the irrelevant signals out.
One of the simplest and more frequently used methods of improving the RSI signal is the adjustment of the period length of regular RSI. A 21-day RSI is smoother and, thus, for less liable to noise and for the purpose of better understanding the real market momentum . By indicating a very clear market signal, longed periods must be used to build RSI filters to eliminate the irrelevant trades.
One of the ways the RSI is applied in a more sophisticated way is through using it in combination with other technical indicators. For instance, when a Buy signal is indicated because RSI moves to above 30 zones above 70 crease, and it could be confirmed by a bullion signal indicated as a quick line to below the sluggish line crossover, this would also apply to ADI. The RSI also suggests maintenance of a bullish formation and a disregard of RSI indications of overbought conditions that have remained above the 70 zones for a considerable period.
The following example illustrates the practical application of previously described methods. The graph indicates RSI and MACD of a certain stock. The RSI uses the 21-day period to filter out the noise . When the RSI appears to be demonstrating an overbought condition, the MACD never provides a signal to sell. This way, the trader who follows this combination of RSI and MACD should have avoided a false Sell indicated by RSI way before May.
Integrating Trend Lines for Decision Making
Utilizing the Relative Strength Index with trend lines allows traders to reach a better decision under the forces of market trends and momentum indicators. Fundamentally, trend lines are a two-dimensional level of the price in a certain time frame; when this two-dimensional picture is superimposed over price changes, the effects of the latter become more perceivable . One can effectively couple trend lines with RSI through the following steps:
Identify major high and low points of the price in the trend. Points where the price is either high or low in a given run would also be high or low; these points are connected by one or more trend line segments, indicating the resistance or support at the time.
Follow the RSI and in which direction it meets the trend lines. The RSI converges to the resistance when the price goes to the resistance; in the event that a price is converging to a trend line from below when RSI is below 30, it indicates an increasing likelihood of a bullish reversal when the price moves above the trend line.
To illustrate how this system can be effectively employed, consider a scenario where a stock is in a downtrend, and its RSI never goes above 40, demonstrating a high degree of bearishness. As the price approaches the downward trend line from below, the ideal conditions for the RSI to break out is when it is above 40 . Such an instance may potentially provide a signal for a bullish move before the breakout of the price. Through this process, traders would be better off using RSI by combining it with trend lines. While the combination not only makes the price points stronger, it also provides a means to anticipate where the breakouts go. For instance, if a stock has been on a downtrend and the trend has started leveling and RSI has been going up, the stock will start an uptrend.
Comparing Different Time Frames for Confirmation
Multiple time frame analysis is a key strategy for traders who use the Relative Strength Index . This technique allows traders to analyze market trends and momentum across multiple time scales, thereby confirming trading signals and improving their decisions. The process for integrating multiple time frame analysis with RSI proceeds as follows:
-
The first step is to designate the primary and secondary time frames. Generally, a trader will consider a longer time frame to determine the overall market trend and a shorter time frame to identify their entry and exit opportunities.
-
The second step is to analyze the RSI on both time frames. For example, if the RSI on the BAC weekly chart gives an “overbought” signal, and at the same time, the RSI on the daily chart has just started to decline from the 70 level, then the “overbought” signal is highly probable; and since both time frames confirm it, it gives more confidence in the forecast than each of the signals taken separately.
Consider an example. A trader monitors the RSI for a particular stock on both the daily chart and the 4-hour chart. The RSI on the daily chart gradually nears the 70 level and reaches 67. It can be assumed that these indicators point to an overbought condition, but the trader waits to receive a signal from the 4-hour chart. As a result, the 4-hour chart also shows the RSI reaching an overbought signal by the end of the day. Consequently, given the signal on both time frames, the trader decides to sell since there is a higher probability of a reversal. Therefore, by analyzing the RSI on both time frames, the traders eliminate potentially erroneous signals. Since the time frames do not always provide confirmations, the trader is allowed to be more confident in their results and more effectively execute strategies while managing risks.
