RSI (Relative Strength Index)

The Relative Strength Index (RSI) is one of the most widely used momentum indicators in technical analysis. It helps traders assess the speed and change of price movements, providing critical insights into whether a security is overbought or oversold. By analysing RSI, traders can identify potential reversal points, understand market sentiment, and time their trades more effectively.

In this article, let’s break down how the RSI works, how traders interpret it, and how it can be applied to different trading strategies.

How Does the RSI Work?

The RSI is a momentum oscillator that measures the magnitude of recent price changes. The RSI value ranges from 0 to 100, with readings above 70 indicating that a security is overbought and readings below 30 suggesting that a security is oversold. These extreme values can signal that a reversal may be near.

The RSI is calculated using the following formula:

RSI = 100 − (100 ÷ (1 + RS))

(Where RS is the average of x days' upward price movements divided by the average of x days' downward price movements.)

Traders typically use the 14-day RSI as a standard, although shorter or longer timeframes can be used based on a trader’s preference.

Image Courtesy: Tradingview

Interpreting the RSI

The RSI provides traders with valuable information about market momentum and potential reversals. Here are the key ways traders interpret RSI readings:

1. Overbought and Oversold Conditions

• Overbought: If the RSI reading is above 70, it suggests that the asset is overbought, meaning it has been rising too quickly and may be due for a pullback or correction.

• Oversold: If the RSI reading is below 30, it indicates that the asset is oversold, suggesting that the price may have dropped too far, and a rebound could be likely.

Image Courtesy: Tradingview

Traders often use these extreme levels to spot potential reversal points. However, overbought and oversold conditions don’t always guarantee an immediate reversal; they simply signal that the market may be overextended.

2. RSI Divergence

Divergence occurs when the price of a security is moving in the opposite direction of the RSI. This can signal that a reversal is imminent:

• Bullish Divergence: The price makes lower lows, but the RSI makes higher lows. This suggests that the bearish momentum is weakening, and the price may soon reverse upward.

• Bearish Divergence: The price makes higher highs, but the RSI makes lower highs. This indicates that bullish momentum is fading, and the price may soon reverse downward.

Image Courtesy: Tradingview

Image Courtesy: Tradingview

3. RSI Swing Rejections

The RSI Swing Rejection is another signal that traders watch for. It occurs when the RSI moves out of the overbought or oversold territory and then reverses:

Bullish Swing Rejection: The RSI dips below 30 (oversold), rises back above 30, and then moves back down slightly before rising again. This signals a buying opportunity.

Image Courtesy: Tradingview

Bearish Swing Rejection: The RSI rises above 70 (overbought), falls below 70, and then moves up slightly before falling again. This signals a selling opportunity.

Image Courtesy: Tradingview

How Traders Use RSI

The RSI can be used in various trading strategies, both by itself and in combination with other technical indicators. Here’s how traders typically use the RSI:

1. Identifying Reversals

When the RSI reaches extreme levels (above 70 or below 30), it signals that the market may be overbought or oversold, making it ripe for a reversal. Traders look for confirmation from other indicators or price action before acting.

2. Confirming Trends

The RSI can also be used to confirm the strength of a trend. For example, in a strong uptrend, the RSI will often stay above 40, while in a strong downtrend, the RSI will remain below 60. Traders can use these levels to confirm whether the trend is likely to continue.

3. Combining RSI with Other Indicators

Many traders combine the RSI with other technical indicators to improve the accuracy of their trades. For example:

• Using Moving Averages to identify the overall trend and the RSI to time entries and exits.

• Combining the RSI with MACD to confirm momentum and avoid false signals.

Example: Using RSI in Reliance Industries

Let’s say Reliance Industries has been in a steady uptrend, and the price reaches a new high. However, the RSI crosses above 70, signalling that the stock may be overbought. At the same time, traders notice a bearish divergence: while the price is making new highs, the RSI is making lower highs. This suggests that the upward momentum is weakening, and the price may soon reverse. Traders might choose to sell or take profits at this point, anticipating a correction.

RSI Settings for Different Trading Styles

While the 14-day RSI is the most commonly used setting, traders can adjust the time period based on their trading style:

• Short-term traders may use a 7-day or 9-day RSI for quicker signals. These shorter timeframes are more sensitive to price movements but may produce more false signals.

• Long-term traders may use a 21-day or 30-day RSI for smoother, more reliable signals that are less prone to short-term fluctuations.

Common Mistakes to Avoid

While the RSI is a valuable tool, it’s essential to use it correctly. Here are some common mistakes to avoid:

• Ignoring the Overall Trend: The RSI is more reliable when used in conjunction with the broader trend. For example, in a strong uptrend, overbought conditions may persist for extended periods, and selling based solely on an RSI reading above 70 could result in missing further gains.
  

• Relying Solely on RSI: The RSI should be used in combination with other indicators or price patterns to confirm signals and avoid false breakouts or reversals.
  

• Overreacting to Overbought/Oversold Levels: Just because the RSI reaches extreme levels doesn’t mean a reversal will occur immediately. It’s crucial to wait for confirmation from other technical indicators.
  

Conclusion

The RSI (Relative Strength Index) is a versatile and widely used momentum indicator that provides valuable insights into overbought and oversold conditions. By understanding RSI levels, divergence, and swing rejections, traders can use the RSI to time their trades more effectively and manage risk.

In the next chapter, we will explore the Stochastic Oscillator, another momentum indicator that helps traders spot potential reversal points in the market.