relative strength index

Technical analysis (TA) is essentially the practice of examining previous market events in an attempt to predict future trends and price action. From traditional markets to cryptocurrency markets, most traders rely on specialized tools to perform technical analysis, and RSI is one of them.

The Relative Strength Index (RSI) is a TA indicator that emerged in the late 1970s as a tool that allows traders to examine a stock's performance over a specific period of time. Essentially, it is a momentum oscillator that measures the magnitude and speed (velocity) of price movements. RSI can be a very useful tool depending on a trader's personal situation and how they trade.

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

Wilder worked as a mechanical engineer and real estate developer before becoming a technical analyst. He began trading stocks around 1972, but was not very successful. A few years later, Wilder organized his trading research and experience into mathematical formulas and indicators, which were later adopted by many traders around the world. The book was published in just six months, and despite being a product of the 1970s, it is still used by many chartists and traders today.

How does the RSI indicator work?

The RSI by default measures the price of an asset over a 14-period period (14 days for a daily chart, 14 hours for an hourly chart, and so on). The indicator is calculated by dividing the average gain the price has made during that period by the average loss it has sustained, and then plotting the data on a scale of 0 to 100.

As mentioned earlier, RSI is a momentum indicator used to measure the speed of price (or data) changes and is a technical trading tool. When a stock's momentum increases and the price rises, it indicates that the stock is being actively bought in the market. If momentum increases and the price falls, it indicates that selling pressure is increasing.

RSI is also an oscillator that makes it easier for traders to spot whether market conditions are overbought or oversold. The indicator measures asset prices over 14 periods and evaluates them on a scale of 0 to 100. If an asset's RSI score is 30 or below, it indicates that its price may be near its lowest price (oversold), while a score above 70 indicates that the asset's price may be near its highest price (overbought) during that period.

While the default setting for the RSI is 14 periods, traders can choose to modify the number of periods to increase sensitivity (decrease the period) or decrease sensitivity (increase the period). Therefore, the 7-day RSI is more sensitive to price fluctuations than the 21-day RSI. In addition, when choosing a short-term trading approach, the RSI indicator can be adjusted to consider 20 and 80 as oversold and overbought levels (rather than 30 and 70), so the indicator is less likely to provide false signals.

How to use RSI based on divergence

In addition to being able to identify potential oversold and overbought market conditions through the RSI scores (30 and 70), traders can also use the RSI to try to predict trend reversals or to find support and resistance levels. This approach is based on what is known as bullish divergence and bearish divergence.

A bullish divergence occurs when the price and the RSI score move in opposite directions. That is, as the RSI score increases, the lows increase while the price decreases, resulting in lower lows. This is called a "bullish" divergence and indicates that buying power is increasing despite the downward trend in prices.

Conversely, a bearish divergence indicates that market momentum is decreasing despite rising prices. Therefore, the RSI score decreases, the high price decreases while the asset price increases, resulting in a higher high price.

However, please note that RSI Divergence is not as reliable in strongly trending markets. In other words, when the downtrend is strong, there may be multiple bullish divergences before the price actually bottoms out. Because of this, RSI Divergence is more suitable for less volatile markets (sideways or subtle trends).

Summarize

There are several important factors to consider when using the Relative Strength Index, such as context, scores (30 and 70), and bullish/bearish divergences. But always keep in mind that no technical indicator is 100% effective, especially when used alone. Therefore, traders should consider using the RSI indicator in conjunction with other indicators to avoid false signals.