Today we're going through everything you need to know about the RSI indicator. What it does, how to use it, and why it works.
If you’re new to trading, this will get you up to speed fast. If you’re more experienced, it will be a nice refresher and I’m confident you will pick up at least a few new points – bringing you closer to trading mastery.
RSI is arguably one of the simplest and most powerful indicators and mastering it will instantly improve your trading performance.
Trade smarter, earn more.
Signal can help.
What is RSI?
Indicator type: momentum
Experience level: intermediate
RSI stands for Relative Strength Index.
It measures the momentum behind price action. More specifically, it measures how consistent the price action has been.
- High RSI: consistent upward price action
- Mid-range RSI: irregular price action
- Low RSI: consistent downward price action
The analogy of momentum is an appropriate one.
Like a ball rolling up a hill, if the momentum is high it's likely to keep climbing and, when it runs out, start falling back down.
What is RSI used for?
When trading, you know that you should trade with the trend.
The question then becomes, how much longer will the trend continue?
This is where RSI comes in. It is used for gauging the strength of the trend.
This is key, because it means you have an early indication of when the trend is going to reverse.
With this, you can time your entries and exits more precisely.
If you’ve ever wondered “how much higher/lower can this go?”, then RSI is what has been missing from your life.
How is RSI calculated?
The way RSI is calculated isn't overly complicated, but is beyond the scope of this article. I'll do a deep dive in a future piece.
For now, the key things you need to know are the 3 terms:
- How much gain occurred
- How much loss occurred
- How many periods to consider
The default for the number of periods is 14.
This means that if you’re on the daily chart, it’s over the past 14 days. If you’re on the hourly, it’s over the past 14 hours.
How to use RSI?
You know that it's for measuring "momentum", aka price action consistency.
And you know the purpose of measuring this is so that you know when an uptrend is likely to stop so you can exit your longs and get ready with your shorts.
Similarly you know when a downtrend is likely to stop so you can exit your shorts and get ready with your longs.
There are 3 main ways to use RSI to do this:
- 70/30 levels
- Mid-point level
Setting RSI up
Before you can actually trade RSI, you need to add it to your graphs.
Go to TradingView (or your charting software of choice) > indicators > RSI
Now you should have something like the following. Note that your chart probably won’t have that center line at around 50.
We’re going to need it, so go ahead and add that (alt+h for Windows, option+h for Mac).
Looking on the indicator’s chart, it should be clear that the 70 and 30 levels are marked and important.
Above 70 is the overbought region and below 30 is oversold.
In order for RSI to get into the above 70 range, the price must have pretty consistently been moving upwards. The longer it is in that range, the longer the market was aligned – pushing the price upwards.
But consistent, unflinching, growth is unsustainable. Eventually the price will start moving sideways or downward. When this happens, you will see the RSI drop.
This indicates that the rally is losing momentum. Price might still be increasing a small amount, but not with the same conviction it had before. It is an early indicator that a reversal is coming.
Overbought Signal (better for bear market)
The signal is generated when the RSI crosses from above 70 to below 70. Note: it is when it crosses back down, NOT when it enters the 70 range, that generates the signal.
- Exit: Close your long (the rally is ending)
- Entry: Open a short (a reversal is coming)
Oversold Signal (better for bull market)
The 30 level behaves in much the same as the 70 level. When the RSI is below 30, the price has been consistently moving downwards.
When the RSI crosses from below 30 to above, a signal is generated.
- Exit: Close your short (the downtrend is ending)
- Entry: Open a long (a reversal is coming)
Easy enough, right?
There is one other point you need to know if using the 70/30 signals. You should trade with the trend.
You can use the signals to offer guidance on exits to some extent, but as entry criteria, it’s risky to use them in the inappropriate market.
Why does this work?
Imagine this situation. It’s a bull market, but the price has been consistently moving downward lately.
In fact, it has been moving quite aggressively down, but it has lost its momentum.
Since it is an overall bull trend, it has now clearly overextended itself in the sell direction. You open a long and ride the price back up.
Remember the line we added to the center of the RSI graphs earlier? This is where that comes in handy.
The midpoint, 50, represents complete indifference in price action. The ups and downs are perfectly balanced. For this reason, when there is sideways price action, the RSI will be pulled towards 50, regardless of which side it happens to be on.
When the RSI is above 50, it is more bullish. When it is below, more bearish.
Using these observations, you can tell a few important things about the trend just from comparing the RSI to the midpoint level.
Identifying periods of consolidation
If you see the RSI repeatedly cutting the midpoint level, it means that the asset is in a period of consolidation.
Since periods of expansion often follow periods of consolidation, you can use this to get ready for a breakout.
Assuming you use Signal for your trade management, you would first identify the consolidation and then place your breakout buy order (stop-market) as shown below.
Identifying whether it is bullish or bearish
If you see that the RSI is consistently above 50 then you know that the trend is overly bullish. You can use this observation to make better predictions.
Specifically, if the RSI has been consistently above the 50 line, then you can use the 50 line as support. Breaches of that support indicate a change in trend behaviour, which usually result in a pretty substantial price drop.
The same is true of the below 50 range. If the RSI has been in that region for a while then the midpoint line acts as a resistance level.
Usually RSI follows the price action to some degree. Occasionally, however, it doesn’t.
This is called a divergence.
Just like overbought/oversold signals and failure swings (next section), divergences give you information about the strength or weakness of the current trend.
With this information, you can be prepared for a trend reversal. Whether that means opening a new position or choosing to exit your existing one.
There are 2 bullish and 2 bearish divergences. Each has a "standard" one, as well as the harder-to-spot "hidden" one.
1) Standard: Price forms a lower low and RSI forms a higher low
The price is still moving downwards, but less consistently, as shown by the increasing RSI.
When you see this, the downtrend is weakening. It is a sign of a potential reversal.
2) Hidden: price forms a higher low and RSI forms a lower low
The hidden bullish divergence is used to signify a continuation.
Given the math behind how the RSI is calculated, this can occur in situations where there is upward movement and then a steep correction.
1) Standard: price forms a higher high and RSI forms a lower high
Similar to the standard bullish divergence except the opposite.
The price is still moving upwards, but less consistently, as shown by the decreasing RSI.
When you see this, the uptrend is weakening. It is a sign of a potential reversal.
2) Hidden: price forms a lower high and RSI forms a higher high
Similar to the hidden bullish divergence, the hidden bearish divergence also signify's a continuation, except this time in the bear trend.
You should now be more familiar with the RSI. What it is and how to use it for gauging the strength or weakness of trends.
I hope that you use this new knowledge to better time your entries an exits and become a more profitable trader.
If you trade cryptocurrency then you should be using Signal. It offers simple automation that saves you time and increases your results. Try it free today.
Disclaimer: This is not financial advice. Invest at your own risk.