How to Trade the RSI Indicator

Many traders use the Relative Strength Index (RSI) to identify extreme levels in the market and as a mean reversion indicator to guide their trading decisions.

What is RSI?

The Relative Strength Index (RSI) is a momentum indicator that measures the speed and change of price on a scale of 0 to 100, typically over the past 14 periods. It compares up days and down days to assess the strength of a security's price change.

RSI is a bounded oscillator between 0 and 100, with readings above 50 indicating an uptrend and readings below 50 suggesting a downtrend. Overbought conditions are typically signaled when RSI is above 70, and oversold conditions when RSI is below 30.

RSI is calculated as follows:

RSI = 100 - (100 / (1 + RS))

Where RS (Relative Strength) is the average gain divided by the average loss over a specified period.

How to Trade Using RSI

Traders often use oversold readings (RSI below 30) as an opportunity to "buy the dip" and enter bullish positions. Conversely, overbought readings (RSI above 70) may indicate a potential pullback, but strong trends can sustain high RSI readings for an extended period.

The midpoint of RSI is 50, and it can be used as a moving average indicator. A bullish cross of 50 signals a change in trend and can serve as an entry indicator. Traders may also use the RSI midline for exit criteria, exiting a bullish position when RSI falls from 70 to 50 as upward momentum weakens.

RSI can be applied to various timeframes, including intraday, daily, and weekly charts, based on the closing price for each period.

Trading RSI Divergences

RSI is often used in conjunction with price action to identify divergences. Traders look for higher highs in price coupled with higher highs in RSI for bullish divergence, and a failure swing, where price makes a new low but RSI fails to make a new low, for bearish divergence.

Similar to MACD, RSI is employed to confirm price moves for a security. Confirmation occurs when both the security's price and the RSI indicator give the same trading signal.

FAQs

Is a high RSI good or bad?

A high RSI reading, over 70, is neither inherently good nor bad. It may indicate that a security is temporarily overbought, but prices can continue to increase for an unknown period. RSI above 70 suggests caution and a potential for a pullback.