How to trade with RSI?

Introduction

Technical Indicators are a mathematical formula calculated from price data to provide traders with information that cannot be easily shown from the pure prices, such as momentum and volatility. Indicators have two major classifications. The first is trend-following, like moving averages and Bollinger Bands, while the second type are Oscillators, such as RSI and Stochastics.

What is the Relative Strength Indicator (RSI)?

The Relative Strength Index (RSI) is most commonly used as a momentum oscillator, which measures the relative strength between the buying power and selling power over a specific period. J. Welles Wilder invented this indicator in 1978

It oscillates between a scale of 0 to 100, whereby an area above 70 is known as overbought, whereas a reading below 30 is known as an oversold area.

If the RSI moves above 70, this suggests that buyers are being overly aggressive, which might lead to some relief in the price movement due to some profit-taking. The same applied when the RSI moves below 30. These levels imply that the sellers are highly aggressive, which could lead to a upward reversal after short sellers take their profits. 

How to calculate RSI 

               RSI = 100 – (100 / 1+RS)

    RS = Average Up days / Average down days

Average Up Days = Sum of Gains over the past 14 periods / 14.

Average Down Days = Sum of Losses over the past 14 periods / 14

Trading with the RSI indicator

You cannot use the RSI signal alone without considering trend analysis. This is because every market phase has a different trading characteristic. In an uptrend, using RSI to time the buy signal will always be the best RSI trading strategy, and in a downtrend, using RSI to time the short signal.

Can you trade only using RSI?

No, as the RSI is just a tool to measure the price movement momentum. Using it alone in absence of other indicators and your own analysis be a limited trading strategy.

How to use the RSI indicator in an uptrend

During an uptrend, buyers mostly have control over price movements. The most effective trades are always around the end of the downward retracement, where the best risk-reward is present.

1. In a strong uptrend, the RSI indicator may not reach the oversold area, so when RSI bounces from the zone between 50-35, this could act as a buying signal, as shown in Figure 1.

Figure 1: RSI in an uptrend, Source: MT5

1. In a normal uptrend, the RSI indictor may reach an oversold area below 30. So the time prices bounce up from this level, it could act as a buying signal, as shown in Figure 2.

Figure 2: RSI in an uptrend, Source: MT5 

When RSI moves above 70, this is known as an overbought area in the uptrend. This means that buyers are aggressive, which could lead to some relief in price due to some profit-taking. 

How to use the RSI indicator in an uptrend

During a downtrend, sellers will mostly have control over price movements. In a strong downtrend, the RSI indicator may not reach the oversold area, so when RSI bounces from the zones between 50-65, this could act as a sell signal, as shown in Figure 3.

Figure 3: RSI in a downtrend, Source: MT5

The RSI indictor could reach an overbought area above 70, and when prices bounce from this level, this could provide a sell signal, as shown in Figure 4.

Figure 4: RSI in a downtrend, Source: MT5

When the RSI moves below 30, this is known as an oversold area in the downtrend. However, it does not necessarily mean it is a good time to buy. It means sellers are aggressive, and could therefore lead to some pressure in prices. 

How to use the RSI indicator in sideways price movements

Sideways movements occur when there is an equilibrium between buyers and sellers. So when the RSI bounces down around the overbought area, this could provide a sell signal, and vice versa when RSI moves higher up around the oversold area, as shown in Figure 5.

Figure 5: RSI with sideways prices, Source: MT5

What is divergence with RSI? 

Most of the time, the RSI indicator follows the price movement. But when it doesn’t, we call this a divergence, indicating weakness in the current trend. There are two types of divergence:

1. Positive Divergence

This occurs when the price makes a lower low, but the indicator makes a higher low, meaning that the current sellers have lost momentum, and a correction could occur.

1. Negative Divergence

It occurs when the price makes a higher high, but the indicator makes a lower high, it means the current buyer is exhausted and loses momentum, and correction might occur, as shown in figure (6)

figure (6)

Trading with RSI divergence 

A divergence signal is a mean reversion because the trade takes a position opposite to the current trend. For example, when a negative divergence appears in an uptrend, a short position could be taken. Similarly, when a positive divergence appears, a long position could be taken since the divergence is an indication of a short-term correction. Divergence signals have a 1:1 risk-reward ratio but have a high probability.

• Positive Divergence Trade

When RSI shows a positive divergence, wait for any candlestick reversal pattern as a buy signal with stop loss below the candlestick pattern and using BB moving average or 50% retracement level as a target as shown in Figure 7.

Figure 7: RSI positive divergence, Source: MT5

• A Negative Divergence Trade

When the RSI shows a negative divergence, traders may wait for any candlestick reversal pattern as a sell signal with stop loss above the candlestick pattern and using BB moving average or 50% retracement level as a target, as shown in Figure 8.

Figure 8: Negative divergence trade, Source: MT5

Conclusion:

RSI is one of the most used and most stable technical indicators out there. Still, it is a secondary indicator that should not be used isolated from the direction of prices, as the trend should always remain as the main indicator. It can give a trend following signal or a mean reversion signal.