Relative Strength Index (RSI) Indicator
Technical analysis (TA) is essentially the practice of examining past market events to try and predict future trends and price movements. From traditional markets to the crypto space, most traders rely on specialized tools to conduct these analyses: the RSI (or IFR in French) is one of them.
The Relative Strength Index (RSI in English, IFR in French) is a TA indicator developed in the late 1970s to help traders analyze the performance of an asset over a given period. It's essentially a momentum oscillator that measures the magnitude of price movements as well as their velocity. The RSI can be a very useful tool depending on the trader's profile and trading setup.
The Relative Strength Index (RSI) was created by J. Welles Wilder back in 1978. It was introduced in his book New Concepts in Technical Trading Systems along with other TA indicators like the Parabolic SAR, Average True Range (ATR), and Average Directional Index (ADX).
Before becoming a technical analyst, Wilder was a mechanical engineer and real estate developer. He started trading stocks around 1972 but didn't have much success. A few years later, Wilder compiled his research and trading experience into mathematical formulas and indicators that have since been adopted by traders worldwide. The book was produced in just six months, and although it's from the 1970s, it remains a reference for many chartists and traders today.
How does the RSI work?
By default, the RSI measures price changes of an asset over 14 periods (14 days on daily charts, 14 hours on hourly charts, etc.). The formula divides the average gain that the price has made during this period by the average loss it has suffered, then plots the data on a scale from 0 to 100.
As we mentioned, the RSI is a momentum indicator, a type of technical trading tool that measures the speed at which price (or data) changes. When momentum increases and the price is rising, it indicates that the asset is being actively bought in the market. If momentum decreases, it’s a sign that selling pressure is increasing.
The RSI is also an oscillating indicator that allows traders to more easily spot overbought or oversold market conditions. It evaluates the asset's price on a scale of 0 to 100, taking into account the 14 periods. If an RSI of 30 or less suggests that the asset is likely near its low (oversold), a reading above 70 indicates that the asset's price is likely near its high (overbought) for that period.
Although the default setting for the RSI is 14 periods, traders can choose to modify it to increase sensitivity (fewer periods) or decrease it (more periods). Therefore, a 7-day RSI is more sensitive to price movements than an RSI that considers 21 days. Additionally, short-term trading setups may adjust the RSI to consider 20 and 80 as oversold and overbought levels (instead of 30 and 70) to provide fewer false signals.
How to use the RSI based on divergences
Besides the RSI scores of 30 and 70, which may suggest an oversold or overbought market, traders also use the RSI to try to predict trend reversals or spot support and resistance levels. Such an approach is based on so-called bullish and bearish divergences.
A bullish divergence is a condition where price and RSI scores move in opposite directions. Thus, the RSI score increases and creates higher lows while the price drops, creating lower lows. This is called a 'bullish' divergence and indicates that buying strength is increasing despite the downtrend in prices.
Conversely, bearish divergences can indicate that despite rising prices, the market is losing momentum. Consequently, the RSI score drops and creates lower highs while the asset's price increases and creates higher highs.
However, keep in mind that RSI divergences are not as reliable during strong market trends. This means that a strong downtrend can present many bullish divergences before the actual bottom is finally reached. Therefore, RSI divergences are better suited for less volatile markets (with sideways movements or subtle trends).
To conclude
There are several important factors to consider when using the RSI, such as the parameters, the scores (30 and 70), and bullish/bearish divergences. However, it's always essential to remember that no technical indicator is 100% effective, especially if used alone. Therefore, traders should consider using the RSI alongside other indicators to avoid false signals.