What Is the Relative Strength Index (RSI) Indicator?
Technical analysis uses the relative strength index (RSI), a momentum indicator. To assess whether a security’s price is overvalued or undervalued, RSI evaluates the speed and amplitude of recent price fluctuations.
An oscillator (a line graph) representing the RSI is shown, with a scale from 0 to 100. J. Welles Wilder Jr. create the indicator, which he first published in his groundbreaking 1978 book New Concepts in Technical Trading Systems.
Beyond identifying overbought and oversold assets, the RSI has other capabilities. It may also signal assets that are poised for a price correction or trend reversal. It can serve as a buying and selling cue. A value of 70 or higher on the RSI traditionally denotes an overbought situation. A reading of 30 or below indicates an oversold condition.
RSI Indicator Is Important, But Why?
Traders can use the RSI indicator to forecast a security’s price behavior.
- It can support trend identification and trend reversals for traders.
- It may indicate securities that have been overbought or liquidated.
- It can offer buy and sell indications to short-term traders.
- It is a technical indicator that supports trading techniques when combined with others.
Using the RSI Indicator With Trends
Modify RSI Levels to Fit Trends
It’s essential to understand the security’s main trend in order to interpret RSI signals correctly. For instance, renowned market analyst Constance Brown, CMT, suggested that an oversold reading by the RSI in an uptrend is likely much higher than 30. A reading that is overbought during a downturn is also substantially lower than 70.
The following chart illustrates how the RSI peaks near 50 rather than 70 during a decline. Traders might interpret this as more consistently signaling bearish conditions. When a strong trend is present, many investors draw a horizontal trendline between the levels of 30 and 70 to more clearly define the overall trend and extremes.
On the other hand, when the price of a stock or asset is in a long-term horizontal channel or trading range (rather than a strong upward or downward trend), it is typically unnecessary to change overbought or oversold RSI levels.
In contrast to trading ranges, the relative strength indicator is less trustworthy in trending markets. Most traders, in fact, are aware of the signals provided by the RSI in strong upward or downward trends often can be false.
Make Use of Signals to Buy and Sell That Match Trends
A related idea concentrates on trend-conforming trade signals and strategies. To put it another way, using signals that are predominantly bullish when the price is in a bullish trend and predominantly bearish when a stock is in a bearish trend may aid traders in avoiding false alarms that the RSI can cause in trending markets.
Overbought or Oversold
On the RSI chart, the RSI indicator typically crosses 30 to indicate a bullish signal and crosses 70 to indicate a bearish signal. Or, to put it another way, RSI values of 70 or higher might be taken to mean that a security is starting to become overbought or overvalued. A trend reversal or corrective price retreat may be imminent. An oversold or undervalued state is indicated by an RSI reading of 30 or lower.
When a security trades over its actual (or intrinsic) value, it is said to be overbought. This indicates that it is overpriced in the opinion of practitioners of technical analysis or fundamental analysis. Traders who see signs of an overbought asset may anticipate a market correction or trend change. So they could sell the security.
The same reasoning holds true for securities that technical tools like the relative strength index flag as oversold. It can be said to be trading for less than it ought to. Traders keeping an eye out for such a sign may anticipate a price correction or trend reversal and purchase the security.
Interpretation of RSI indicator and RSI Ranges
The RSI readings may fall into a band or range during trends. The RSI tends to remain above 30 and should frequently reach 70 during an uptrend. Rarely does the RSI rise above 70 while the market is in a decline. The indicator frequently falls to 30 or lower, in reality.
These criteria can assist traders in assessing the strength of a trend and identifying potential reversals. If during an uptrend, the RSI cannot reach 70 on several consecutive price movements but then falls below 30, the trend has weakened and may be about to reverse lower.
For a downturn, the converse is true. The downtrend has weakened and may be about to reverse to the upside if it fails to dip below 30 and then rises over 70. When using the RSI in this manner, trend lines and moving averages are beneficial technical tools to incorporate.
Example of Positive-Negative RSI Indicator Reversals
Positive and negative RSI reversals are another relationship between price and RSI that traders watch for. When the RSI achieves a low that is lower than it’s previous low and a security’s price reaches a low that is higher than its prior low price, a positive RSI reversal may occur. This configuration would be regarded by traders as a buy signal and a bullish omen.
In contrast, when the RSI hits a high that is higher than its prior high and the price of an asset hits a lower high, a negative RSI reversal may occur. This pattern would be a sell signal and a negative indication.
Example of RSI Indicator Swing Rejections
Another trading strategy looks at how the RSI behaves as it exits an overbought or oversold area. This signal, which is also known as a bullish swing rejection, includes four components:
- The RSI crosses the oversold line.
- The RSI returns to crossing over 30.
- The RSI takes another plunge without entering the oversold zone once more.
- Then, the RSI reaches a new high
The RSI indicator was oversold, broke through 30, and established the rejection low that caused the signal to be sent when it bounced higher, as shown in the following chart. Drawing trend lines on a price chart is quite similar to how the RSI is used in this instance.
The swing rejection signal has a negative counterpart that is the exact opposite of the bullish counterpart. Four elements make up a bearish swing rejection as well:
- The RSI increases and enters the overbought zone.
- The RSI dips again under 70.
- The RSI establishes yet another high without entering the overbought zone once more.
- The most recent low is then broken by the RSI.
The bearish swing rejection indication is depicted in the following graph. Similar to most trading strategies, this signal will be most trustworthy when it follows the dominant long-term trend. Bearish signs are less prone to cause false alarms when trends are falling.
Limitations of the RSI indicator
Underneath a price chart, the RSI oscillator compares bullish and bearish price momentum and outputs the results. Its signals, like those of other technical indicators, are most trustworthy when they follow the long-term trend.
True reversal signals are uncommon, and it can be challenging to distinguish them from false alarms. For instance, a bullish crossover followed by a sharp drop in stock would be a false positive. A false negative would occur if a bearish crossover occurred but the stock then sharply increased.
The indicator shows momentum, therefore when an item has strong momentum in either direction it may be overbought or oversold for a long time. In a market that oscillates (a trading range), the RSI is therefore most effective when the asset price alternates between bullish and bearish moves.