What is the RSI Indicator?

Essentially, Technical Analysis (TA) involves predicting future market trends by examining past movements. From the traditional market to the cryptocurrency market, most traders rely on special indicators and tools to analyze past information as a way to identify market patterns, and perhaps predict upcoming price movements.

The Relative Strength Index (RSI) is a technical analysis indicator developed in the late 1970s as a tool that stock market traders used to examine the behavior of a stock over a specific period of time. He is basically a momentum analyst who measures the magnitude of price movements in addition to the speed of those movements. The RSI can be a very useful tool depending on the type of trading you do and is widely used by many traders and technical analysts.

In 1978, a mechanical engineer named J. Welles Wilder focused his analytical training on the technical aspect of trading. He began his career in the real estate industry. After his partners bought all his properties in 1972, he took the profit of R$100,000.00 and soon after started trading on the stock exchange. During these years, he started looking for reliable tools to identify profitable patterns. Also in 1928, Wilder compiled his research and experience into mathematical formulas and indicators that people could use in trading. The RSI was one of these indicators created by him.

How does the RSI indicator work?

By default, RSI measures an asset's price changes over 14 periods (14 days for daily charts, 14 hours for hourly charts, and so on). The formula consists of dividing the average gain that the price has had during that time by the average loss it has suffered and then organizes the calculation on a scale of 0 to 100.

As mentioned, the RSI is a momentum indicator, which is a type of technical tool for trading, measuring how frequently the price is changing. When momentum is increasing, it indicates that the stock is being actively bought in the market. If momentum slows, it is a sign that traders' interest in a particular stock is falling.

The RSI also works as a swing indicator that makes it easier for traders to identify overbought or oversold market conditions. It evaluates the price of an asset on a scale of 0 to 100, considering 14 periods. While an RSI score of 30 or less means the asset is likely close to its base (oversold), a measurement above 70 points suggests the asset's price is close to its top (overbought) for that period and will likely decline. .

Although the indicator defaults to 14-period settings, traders can make modifications to increase sensitivity (fewer periods) or decrease sensitivity (more periods). However, a 7-day RSI is more sensitive to price movements than one that considers 21 days. What's more, some trading strategies may adjust the indicator to consider 20 and 80 as overbought and oversold levels (as opposed to 30 and 70) making it less likely to indicate false signals.

RSI divergences

In addition to RSI scores of 30 and 70 – which can potentially suggest oversold and overbought market conditions – traders also use RSI to try to predict pattern changes or to identify support and resistance levels through Bullish divergence patterns. and Bearish (bearish).

Bullish divergence is a condition where an asset's price moves and the RSI moves in the opposite direction. Then, the RSI score grows and creates a higher low while the price falls, creating lower lows. This is called a bullish divergence and indicates that momentum is getting stronger despite the price's downtrend.

In contrast, bearish divergences may indicate that despite the price rising, the market is losing momentum. Therefore the RSI score falls and creates lower highs while the asset price increases and creates higher highs.

Keep in mind, however, that RSI divergences are not as reliable during very strong market trends. This means that a strong downtrend could represent bullish divergences before the bottom is finally reached. Because of this, RSI divergences are more suitable for less volatile markets (with sideways movements or subtle trends).

How to use RSI?

There are several important factors to consider when using the RSI indicator, such as the settings, the score (30 and 70), and the bullish/bearish divergences. However, it is necessary to keep in mind that no technical indicator is 100% efficient – ​​especially if used alone. Therefore, traders should consider using RSI along with other indicators to avoid false signals.