Relative Strength Index (RSI) Indicator

Essentially, technical analysis (TA) is the examination of previous market events to predict future price trends and actions. From traditional markets to cryptocurrency markets, most traders rely on specialized tools to perform these analyzes and RSI is one of them.

The Relative Strength Index (RSI) is a technical analysis indicator developed in the late seventies as a tool that stock traders can use to check the performance of a stock. like over a period of time. It is essentially a momentum oscillator that measures the magnitude of price movements as well as the speed (velocity) of these movements. RSI can be a very useful tool depending on the trader's profile and their trading setup.

The Relative Strength Index indicator was created by J. Welles Wilder in 1978. It was presented in his book New Concepts in Technical Trading Systems, along with other TA indicators, such as Parabolic SAR, Average True Range (ATR), and Average Directional Index (ADX).

Before becoming a technical analyst, Wilder worked as a mechanical engineer and real estate developer. He started trading stocks around 1972 but was not very successful. A few years later, Wilder compiled his research and trading experience into mathematical formulas and indicators that were later applied by many traders around the world. The book was only six months in production, and although it dates from the 1970s, it is still a reference for many analysts and traders today.


How does the RSI indicator work?

By default, RSI measures changes in the price of an asset over 14-digit time periods (14 days on a daily chart, 14 hours on an hourly chart, etc.). The index is determined by dividing the average price increase by the average price decrease over the measurement period and then expressing the index on a scale set from 0 to 100.

As mentioned, RSI is a momentum indicator, which is a type of tool that measures the rate of price (or data) fluctuations. The increasing momentum shows that the stock is being actively bought in the market. The decline is a sign that trader interest in the stock is slowing.

RSI is also an oscillating indicator that helps traders easily detect overbought or oversold conditions in the market. It evaluates asset prices on a scale of 0 to 100, dividing time into 14 intervals. When RSI scores below 30, it indicates that the asset price may be close to bottoming (oversold); If the RSI scores above 70, it indicates that the asset price is near its peak (overbought) for that period and is likely to decline.

Although the RSI's default setting is 14 periods, traders can adjust it to increase sensitivity (shorter time periods) or decrease sensitivity (more time periods). Therefore, the 7-day RSI will be more sensitive to price movements than the 21-day RSI. Furthermore, short-term trading setups can adjust the RSI to set 20 and 80 as the oversold and overbought levels (instead of 30 and 70), making it less likely to provide false signals. .


How to use RSI based on divergence

Besides RSI scores of 30 and 70 - which indicate possible oversold and overbought conditions in the market - investors also utilize RSI to predict trend reversals or identify support and resistance levels . Such an approach is based on the so-called negative divergence and positive divergence.

Positive divergence is a situation where price fluctuations and RSI move in opposite directions. In this situation, RSI increases creating a high bottom while price decreases creating a low bottom. This is called a “positive” divergence and indicates that momentum is strengthening despite the bearish trend.

Conversely, a negative divergence can indicate that despite rising prices, the market is losing momentum. Therefore, RSI decreases and creates a low peak while the asset price increases and creates a high peak.

However, be aware that RSI divergence is not reliable when the market has strong trends. This means that when the market is in a strong downtrend, there can still be many positive divergences before reaching the real bottom. Therefore, RSI divergences are more suitable for less volatile markets (with sideways movements or unclear trends).


summary

There are several important factors to consider when using the Relative Strength Index indicator, such as settings, levels (30 and 70), and positive/negative divergences. However, you should always remember that no technical indicator is 100% effective - especially if used individually. Therefore, traders should consider using the RSI indicator along with other indicators to avoid false signals.