Wondering how to use momentum in your trading strategy with the power of the Relative Strength Index or RSI?
Let’s face it, consistently profiting in the financial markets is difficult. It requires a lot of research and testing of strategies to find the elusive “holy grail” of trading. Most literature would tell us that there is none. We agree markets move in cycles, and trading strategies continue to evolve. However, focusing on a single strategy or technical indicator can help build a strong foundation for a profitable strategy that offers long-term performance.
What is RSI?
The RSI, or the Relative Strength Index, is a momentum oscillator that measures a security’s speed and change of price movements. It helps traders and investors understand a security’s momentum and see if prices have already overextended or started to turn bullish or bearish, giving signs of divergence and other analysis sets. The technical indicator was developed by J. Welles Wilder in 1978 and has helped traders increase their trading performance to this day.
How To Calculate RSI?
RSI is calculated using a 2-step formula shown below:
Step 1 – Take the relative strength of any security, which can be done by dividing the average loss and average gain of a security for a certain period (highlighted in red). Most trading platforms and users use a standard 14-day look-back period when calculating the loss or gain of the stock market price.
Step 2 – Once the relative strength becomes available, you can plug in all the values in the above formula. The result will give an RSI value that oscillates between 0-100. The value changes every time there is a change in the value of the variables. If the value is more than 70, the stock is considered overbought, and any value lower than 30 indicates heavy selling of that particular stock and is considered oversold.
Benefits of RSI
A simple technical indicator as it may be, RSI offers traders various benefits when applied to their trading strategies. For example:
Identifying Overbought and Oversold Conditions
RSI can provide traders and investors with insights into its overbought and oversold conditions. When the RSI moves beyond 70, it suggests that the security is overbought, indicating that prices have moved too fast, and a potential reversal or correction may be near. Conversely, when the RSI falls below 30, it indicates an oversold market, suggesting that prices have continuously fallen, and a potential buying opportunity may come into play.
Spotting divergence
RSI can help traders and investors identify divergences between momentum and price, which is often an early signal of trend reversals. A bullish divergence happens when the security’s price goes lower than its previous low. At the same time, the RSI makes a low that is higher than its previous one, indicating potential upward momentum due to momentum to the downside waning. Conversely, a bearish divergence occurs when the price registers another high that is higher than the previous one while the RSI gets a lower high, suggesting a potential downward reversal.
Confirm trend strength
RSI can also be used to confirm a security’s existing trend. Once the RSI remains above 50 during an uptrend, it indicates that a security is in a bullish trend. Conversely, if the RSI remains below 50 during a downtrend, it indicates a strong bearish trend.
Limitations of the RSI
Even with the usefulness of RSI, it is not the “holy grail” of all technical indicators, as it has its own limitations. Understanding this limitation lets traders understand when they should or shouldn’t jump in on a trade based on the RSI signal. For example:
Potential whipsaw
One of the drawbacks of RSI is its possibility of generating false signals in rangebound markets and during periods of high volatility. These whipsaw signals can lead to some traders taking premature entries or exits that could result in losses or missing out on potential returns due to solely relying on RSI as a standalone indicator.
Lagging indicator
RSI is a lagging indicator due to its reliability on previous prices. As a result, it may not provide timely signals during rapidly changing market conditions or during market breakouts and can lead to traders or investors being late on their exits or entries to major moves if it’s the only indicator that they will be relying on.
Limitations when used alone
It is always best practice not to use RSI as the only tool to analyze the security or the market; trading analysis requires additional analysis and context to get the full picture of the market and the security’s state. Relying solely on RSI may lead to oversights and missed opportunities for traders and investors. Other tools like fundamental analysis, technical indicators, or market sentiment should also be considered.
How do you apply RSI to your trading?
Now that we know what RSI is, its advantages and limitations, let’s see how we can apply RSI to your trading strategy:
Trend reversals and bounce trades
Traders can often use RSI to identify potential trend reversals when RSI crosses above or below certain threshold levels. This often indicates a possibility of a change in the market direction and provides opportunities to enter or exit positions.
For example, when prices go into oversold territory (below 30) and then start to break above the 30 levels, it is often interpreted as a signal that prices may change their trend. Based on the example below, prices have been moving downward since mid-September, and once they had gone oversold and RSI moved back above the 30 level, prices followed suit.
In another example below, prices started trending and then suddenly corrected, and RSI crossed below the 50 mid-line but did not continue to go lower. It started crossing above the 50 midlines, and prices then continued to move back to continue the trend, offering the RSI trader a chance to ride onto the continuation of the trend given by the correction.
Spotting divergences
RSI is a powerful tool that signals investors and traders that a security’s momentum is slowing and prices are deviating. This gives traders and investors a chance to pick up the security after registering a potential short-term or long-term bottom on its way to recovery. In the example below, AAPL was on a downward trend. Prices went to oversold territory and then started showing a divergence with price to indicate that the momentum is slowing down. Once prices started to break out and the RSI broke above the 30 line, prices continued to move upwards and confirmed the reversal.
Contraction of momentum
Another way to apply RSI to a trading strategy is to spot contractions of RSI movement. In the example below, prices moved in a bearish trend, and once the RSI continued to move into oversold territory, the price started to carve its low. Then RSI started to contract and signal that momentum may expand again and move either to the upside or downside.
Confirmation of the change in trend
RSI provides traders a way to identify securities that have started changing their trend direction. One of the ways traders and investors utilize this is when the RSI crosses over the 50 mid-line. As prices cross above or below, it tells traders and investors that security has now indeed changed its trend. For example, the chart shows that during October-November, prices were falling till they made low and established support, then buyers stepped in, which pushed RSI to move up, as soon as it crossed the 50 lines and held, prices continued to move bullishly. Even though prices corrected as soon as they returned to the +50 mid line, prices continued to move upward following its new trend.
Final Thoughts
The Relative Strength Index, or RSI, is one of the most popular indicators traders and investors use to profit in financial markets. While it provides advantages to traders and investors looking to find reversals, confirm the trend, and detect divergences, it also has its limitations. It is good practice to include other indicators like volume, price actions, and trading strategy patterns to ensure you can get the most out of RSI’s capability. This helps enhance the decision-making process and minimize false signals. In the end, RSI is not a buy signal but a tool that lets you identify opportunities and give you actionable ideas.
