Relative Strength Index
Technical analysis (TA) is a way of predicting future trends and price movements by studying past market events. Technical analysis is widely used in both traditional and cryptocurrency markets. One of its most popular tools is RSI.
Relative Strength Index (RSI) is a technical analysis indicator developed in the late 1970s as a tool for studying the movement of stocks over a specific period. Essentially, it is a momentum oscillator that is used to measure the magnitude and speed of price movements. RSI can be an extremely useful tool depending on the trader's profile and trading strategies.
The Relative Strength Index was created by G. Wells Wilder in 1978. It was featured in his book New Concepts in Technical Trading Systems along with other popular technical analysis indicators such as the parabolic SAR system, the average true range (ATR) and the directional X-ray system (ADX).
Before becoming a technical analyst, Wilder was a mechanical engineer and real estate developer. He started trading stocks around 1972, but was not very successful. Several years later, Wilder combined his research and trading experience into mathematical formulas and indicators that were later used by many traders around the world. He wrote his book in just six months, and although it is almost 50 years old, it still serves as a reference for many analysts and traders.
How RSI works
RSI measures changes in the price of an asset over 14 periods (14 days on daily charts, 14 hours on hourly charts, and so on). The formula divides the average price increase by the average price decrease, and then ranks the resulting data on a scale from 0 to 100.
RSI is a momentum indicator for technical trading that measures the rate of change in price or data. Increasing momentum and rising prices indicate active buying of shares in the market. At the same time, a decrease in momentum indicates an increase in selling pressure.
In addition, RSI allows traders to detect signs of oversold and overbought markets. To do this, the asset price is assessed on a scale from 0 to 100 over 14 periods. If the RSI is equal to or less than 30, it indicates oversold, and if above 70, it indicates overbought.
Although the classic RSI calculation has 14 periods, traders can vary the number of periods to increase (fewer periods) or decrease (more periods) sensitivity to price movements. Thus, the 7-day RSI is more sensitive to changes than the 21-day indicator. When developing short-term trading strategies, RSI signal levels are sometimes assessed at 20 and 80 (instead of 30 and 70) to reduce the likelihood of false signals.
How to Use RSI Based on Divergences
In addition to monitoring RSI levels of 30 and 70, which can indicate potential oversold and overbought markets, traders also use this indicator to try to predict changing trends or identify support and resistance levels. This approach is based on the so-called bullish and bearish divergences.
Bullish divergence is a condition in which price and RSI readings move in opposite directions. For example, the RSI is rising and making high lows, while the price is falling, creating low lows. This indicates strengthening purchasing power in a downward price trend.
A bearish divergence may indicate that despite the price rising, the market is losing momentum. Thus, the RSI falls and creates low highs, while the price of the asset increases, creating high highs.
However, RSI divergences should not be relied upon during significant market trends as a strong downtrend can cause many bullish divergences before a low is reached. Because of this divergence, RSI is best applied to less volatile markets with sideways movements and weak trends.
Summary
When using the relative strength index, there are several important factors to consider such as strategy, levels (30 and 70) and divergences. However, you should always remember that no technical indicator is 100% effective, especially if used in isolation. Therefore, we recommend considering the RSI in conjunction with other indicators to avoid false signals.