In trading, a relative strength index (RSI) is a valuable technical analysis tool which is commonly used to find “overbought” and “oversold” situations in a market. The RSI is displayed as an oscillator below the candlestick chart so to understand what the RSI is telling us, it’s important to know how to read a candlestick chart.
What is a Relative Strength Index?
In short, an RSI is a momentum indicator which shows the magnitude of recent price changes over a set period. The default setting for the RSI is 14 days. It is calculated by taking the average gains and losses over the last 14 days and putting them into the first part of a formula. Once there are 14 days of data available, the second part of the formula can be calculated which smooths out the final result. The formula itself isn’t too important to understand as most charting software includes the RSI as an available tool. What is important is to understand what the graph shows and how to use it to help become a more accurate trader.
The RSI will always have a value between 0 and 100. As the number of candles closing above their open price increases, so will the RSI graph. By the same rule, if there are more red candles, the RSI will drop towards the bottom of the chart. There are two important levels to watch, 70% and 30%. When the RSI rises above 70%, the market is considered “overbought” and when it drops below 30%, the market is oversold.
What to do with the information provided by the RSI
Relative strength index data is usually reliable but, as with any trading tool, false signals can appear. Using other bullish signals during oversold periods and bearish signals during overbought periods can lower the risk of acting on false alarms generated by the RSI. Bull flags and dojis can help if they appear at the same time as situations where the RSI suggests a trend is about to change.
Using the RSI along with the current price on the candlestick chart can allow traders to search for situations of divergence, which are among the most reliable trading signals known to occur. A double top or double bottom can be confirmed by making sure the asset’s momentum is as strong as the move suggests on the RSI. Another strategy which could be lucrative would be to use the RSI to confirm possible signals produced when looking at the MACD as the two graphs don’t always match up. If both the MACD and RSI suggest the same thing, it could be a good trading opportunity.
As is true with all trading signals, trying to find more than one suggestion of a move in the same direction is key. Patience is a trader’s greatest asset as rushing into trades based on little information can often end in unnecessary losses. The RSI is an important graph to understand but it’s not recommended to use it by itself. Search for other signals such as bull flags and engulfing candles and if you can spot moments of divergence, even better!