RSI, short for Relative Strength Index, is one of the most popular indicators used in technical analysis. Before we see how to use this indicator for trading, here is a quick overview of RSI.
What is RSI?
The RSI, developed by J. Welles Wilder is a basic measure of how well a stock is performing against itself. This is done by measuring the ratio of up-moves to down-moves and normalizing the calculation so that the index is expressed in a range of 0-100.
RSI is a leading indicator, which means that it gives a higher opportunity for traders to anticipate and speculate on trends.
Overbought and Oversold Levels
The two important readings of RSI that are to be noted are 70 and 30.
If the RSI reading is above 70, the stock is assumed to be ‘overbought’, which means that the prices have risen more than market expectations. Typically, stocks consolidate or correct when the RSI is higher than 70.
On the other hand, an RSI of 30 or less is considered as the signal that the stock may be ‘oversold’, which means that the prices have fallen more than the market expectations. Hence, there is a possibility that the stock may rally soon when the RSI value is below 30.
Many cautious traders, in a bid to avoid false signals, use RSI value of 80 as overbought level and 20 as oversold level. Some traders use 40 as the oversold level for making an early entry into trades.
The 3 Ways To Use RSI for Trading
There are 3 ways in which RSI can be used for picking up possible winners among the various stocks.
#1 Identifying The Trend of the Stock
Whenever the value of RSI is between 50 and 70, it indicates a bullish trend. The value of RSI between 50 and 30 indicates a bearish trend.
When trading a trending stock, you may place bullish bets when RSI is between 50 and 70 and bearish bets when RSI is between 50 and 30. The figure below shows how trends change based on the values of RSI. You can choose bullish or bearish trades based on these values.
#2 Identifying Upcoming Price Reversals
RSI can be used for predicting price reversals and taking up trades accordingly. When the RSI crosses above 70 (overbought) and starts moving down, it indicates a possible bearish move. Similarly, whenever RSI crosses below 30 (oversold) and starts moving up, it indicates a possible bullish bias. The figure below shows how RSI can be used for price reversals.
#3 Trading Divergences
Divergences happen when the direction of the RSI and the direction of the stock differ. There are two main types of divergences – positive divergence and negative divergence.
If price makes lower lows and RSI makes higher lows, it is called as a positive (bullish) divergence. This means that the price may soon move upwards. If price makes higher highs and RSI makes lower highs, it is called as a negative (bearish) divergence. This means that the price may soon move downwards.
The figure below shows a bearish divergence between RSI and price.
Other Tips to Note
#1 Note Trend Strength: When you choose your trades based on the value of RSI, the strength of the trend should also be considered. For instance, when the stock is in a strong downtrend, the RSI of the stock can remain oversold (below 30) for a prolonged interval. Similarly, during a strong uptrend, the RSI can remain overbought (above 70) for a long period of time. So, you can possibly go short when RSI is oversold in a strong downtrend, and buy when RSI is overbought in a strong uptrend.
#2 Chart Patterns Work: The chart patterns like double bottom work in the case of RSI as well. A bullish chart pattern like double bottom formed in RSI usually foretells an upcoming price surge.