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The Relative Strength Index, or RSI is among the most popular indicators used by traders. The RSI provides information about the strength of the price movements on your charts, hence the name. In this article we will learn what the RSI really does, how to understand what it is showing and how to use it in your own trading.
The introduction – Understanding the RSI
The standard setting for the RSI is 14 periods which means that the RSI evaluates the last 14 candles, or time periods.
For example, if all 14 price candles were bullish, the RSI would be 100 and if all 14 price candles were bearish, the RSI would be 0 (or relatively close to 100 and 0). And an RSI of 50 would mean that 7 past candles were bearish, 7 were bullish and the size of the average gain and loss was equal.
The screenshot below shows the most recent EUR/USD chart and the white highlighted area includes the past 14 price candles. Out of the past 14 candles, 13 were bullish and only 1 bearish candles was printed which resulted in a RSI of 85.
The screenshot below also shows the EUR/USD chart and 3 highlighted areas of 14 candles each to understand how the RSI is being calculated.
The first area marks a very bearish period with 9 bearish candles, 4 very small bullish candles and 1 Doji. The RSI of this period was 15 which signals a very strong bearish phase.
The second are includes 9 bullish candles and 5 (mostly small) bearish candles. The RSI of this period was 70 which is a relative strong bullish move.
The third area includes 6 bullish candles, 8 bearish candles and 1 Doji, resulting in an RSI of 34 which signals moderate bearish strength.
As you can see, just by analyzing the 14 candles you would be able to very accurately guess the RSI for that period. However, using an indicator to show you the actual value can be beneficial to reduce the time you need to process the data and it also avoids misinterpretations during live-moving markets.
Oversold and Overbought
The general idea is that when the RSI shows extremely high or extremely low values (higher than 70 or lower than 30), price is oversold or overbought. But, let’s recap what we have just learned. A high RSI simply means that there were more bullish candles than bearish candles. And although price can’t go on printing only bullish candles forever, it can be dangerous to rely on RSI information alone to call tops and bottoms.
Yes, it is true that if 13 out of the past 14 candles were bullish and when the RSI is way above 70, it is likely that the bulls will probably step back soon, but relying on RSI alone should not be an option. The screenshot below highlights two periods when the RSI entered oversold (below 30) and stayed oversold for a long time. During the first period, price kept falling for 16 days before the RSI turned back above 30 and during the second period, price kept falling for 8 days when the RSI was oversold.
When Support and Resistance breaks
We have just said that the RSI identifies strong trending price movements. And with this knowledge the RSI is a great tool when it comes to support and resistance trading. The screenshot below shows the EUR/USD chart and the black horizontal line is the famous and strong 1.20 price level which acts as support and resistance.
You can see that price went back to the 1.20 price level several times. During the first time, the RSI showed values of 63 and 57 which meant that although the power was more bullish, it wasn’t a very strong trend behind the price movement. A strong resistance level does usually not break easy and it requires a strong trend to make it past the price.
The second time price went back to the level, the RSI was at 71, indicating a fairly strong bullish trend, the resistance level held again. It wasn’t until the last time when the RSI showed a value of 76 that the resistance level broke and price held above it with the RSI going all the way to currently 85.
The RSI can be a useful tool when it comes to quantifying price strength. Especially for rule-based traders who need a certain level of quantifiable data, the RSI comes in handy.
The RSI Divergence
And, finally, another way of using the RSI to identify turning points is by finding divergences. A divergence signals that what price is showing you, is usually not supported by the underlying price dynamics – we will see what this means now.
The screenshot below shows two lower lows. During the first one, the RSI was at 26 and the price movement leading up to that point included 8 bearish candles, 3 bullish candles, 3 Dojis and price went down 1.45% in total. During the second swing low, the RSI showed a higher RSI of 28 and the price move included 7 bearish candles, 5 bullish candles, 2 Dojis and price lost only 0.96%.
Although price made a new, lower low, the dynamics behind the move weren’t as bearish and the second move wasn’t as strong; the RSI shows that. The second low had a higher RSI (28 vs. 26) although price showed a lower low, thus, signaling that the bears are losing strength. Divergences often fail and we have talked about a more reliant type of divergence here: the double divergence.
Conclusion: Know what price is doing
The RSI is a great tool and although you could easily guess what the RSI value by looking at the past 14 candles, plotting the RSI on your charts can add stability and guidance to your trading. If you can quantify price strength and translate it into interpretable numbers, you can make trading decisions more effectively and avoid guesswork and subjective interpretations.
Whether you are using the RSI to identify strength, look for turning points or as a breakout trader, the RSI is your universal weapon. If you enjoyed this article, you should check out our free Knowledge Center where explain other, popular trading indicators and tools.
Image credit: all screenshots have been taken using Tradingview.com