The RSI indicator which falls under the category of oscillator and it is an extremely simple indicator to use in your trading. RSI standards for the Relative Strength Index is often referred to as the RSI. The indicator was created by Welles Wilder who also created a variety of other technical indicators such as the Average True Range and the Parabolic SAR. This is our RSI introduction.
Oscillators to use to help determine when a market is overbought or oversold. When we say overbought or oversold we mean the buying pressure or the selling pressure has run out of steam, making a reversal of price direction more likely. For example, if buying pressure is run out of steam we can expect prices to fall sometime in the near future, so when that situation happens, it can help us pick a selling opportunity, and vice versa for a buying opportunity. So the RSI indicator can help us identify these opportunities and better time our entries and exits.
Since our RSI is an oscillator, we work with values between zero and 100. The value of 100 is extreme buying with the likely chance of a reversal to the downside. The value of 0 is extreme selling with the likely chance of a reversal to the upside. RSI will further identify readings of 70 and over as overbought and readings of 30 or below as oversold. So when the market is 70 or above it’s likely to reverse to the downside with the market 30 or below it’s likely to reverse to the upside.
The RSI Indicator Basics
We use the RSI indicator to determine when the market is overbought or over sold. To do this it takes an average of the price movements over the last 14 periods and displays the results on an index. We simply check whether the RSI indicator is over 70 or under 30, assuming you use the standard settings.
When a market gets into an over sold condition, we often think that the market has to immediately get out of that oversold condition. Therefore so buy assuming that the price will start gravitating towards the top. Or the other way, when a market gets into an over bought condition, we often think that the market has to immediately get out of that over bought condition. We assume it will start falling down again, so we sell. Unfortunately, this is not always the case. The price can stay here for a long time, I mean days, sometimes even weeks. So you can see the problem there. When the RSI indicator moves down below 30 and a trader immediately thinks they’ve got to go long because it’s oversold, the RSI can continue to move lower and lower and lower.
Yes, the trader’s logic is correct, the move will probably happen at some point, but there is nothing to say that it will happen immediately. So how can you trade with RSI effectively? You do this with either a combination of technical indicators, or you use a strategy.
Simple RSI Trading Strategy
To trade with the RSI indicator using this simple strategy, firstly determine whether your market is trending or ranging. To do this, you could use a moving average or simply view the chart and decide manually.
Next, set your RSI indicator up on your market, using standard settings, (only change the settings if you have experience as a trader). The standard settings are normally 14 periods with 70 and 30 as the overbought and oversold level. This indicator will help you look for signals.
Third, use these rules for your strategy, before you look for signals:
- If the market is ranging (no trend) – you can buy or sell. Use both signals
- If the market is trending up, only buy. Ignore sell signals
- If the market is trending down, only sell. Ignore buy signals
Fourth, look for signals and trade them using a stop loss using these trade setup rules:
High Probability Trade Setups – To Buy
- You are either in a ranging market or the market is trending up
- You are near or approaching an area of support
- The RSI indicator is currently below 30 and is about to cross back above 30
- Once the candle closes and RSI is once again above 30, you enter a trade to go long
- Place a protective stop loss under the recent low
- Set a profit target of at least 2 times your stop loss
High Probability Trade Setups – To Sell
- You are either in a ranging market or the market is trending down
- You are near or approaching an area of resistance
- The RSI indicator is currently above 70 and is about to cross back below 70
- Once the candle closes and RSI is once again below 70, you enter a trade to go short
- Place a protective stop loss above the recent high
- Set a profit target of at least 2 times your stop loss
When you are trading with RSI, the situation you want to look for in a potential buying opportunity is a pullback down to support when the market is in an uptrend. And another situation you want to look for, especially when you want to sell, is a rally to resistance when the market is in the down trend.
Markets are known to stay overbought and oversold for a prolonged period of time specifically if it’s in a strong trending move. So we don’t look for sells in and up-trending market and we don’t look to buy in down-trending markets.
RSI has the habit of continuing to get more and more and more overbought or more and more and more oversold. So the signal that you’re looking for is not when it drops into oversold or moves into overbought, but rather when it comes out after having been in there. So if RSI drops below 30 what you’re waiting for for your buy signal is for it to close above 30, that’s your signal to go long. Or after it’s been above 70 when it drops below 70 and closes below 70, that’s your signal to go short.
Advanced Strategy – RSI Divergence
On occasions you will get a false signal, which will stop you out. So let’s say for example the market is trending down and you get a signal to buy the market. You enter the trade and place a protective stop loss as normal, because the RSI indicator is giving you the confirmation you need. But on this occasion the price makes a lower low, and your trade loses. It happens. However in this example, assume that the oscillator does not form a lower low. In these cases you have positive divergence. Price makes a lower low but the oscillator makes a higher low.
This is a strong bullish signal, especially when combined with being at an area of support. Therefore, this is a new opportunity to go long again.
The reverse is also true. You may get a sell signal where the market has rallied to resistance and the RSI indicator is above 70. The price may be ready to go below 70 so you enter to the trade to go short. But instead, the market continues to rally higher and you get stopped out. However RSI has not created a higher high the same way. So if price is making a higher high, but the RSI indicator is making a lower higher, this is negative divergence. When you combine this with an area of resistance, it is a very strong bearish signal. This is new selling opportunity.
Advanced RSI Settings
The RSI indicator can work on any time frame and can work on any market. But as with any other technical indicator, the RSI works better on the longer time frames. You will receive more accurate signals on the daily chart than a lower time frame, but the signals may be less frequent. On the other hand you will receive more signals on a 30 minute chart than a daily chart, but they may be less accurate. So it’s up to you to find a balance to achieve the right number of solid opportunities and the right degree of accuracy of the signals.
Change The Settings
When bringing up an RSI on a chart you will choose the number of periods. The most common settings for the RSI indicator will be to choose a period of 14. Most charting platforms will have a RSI as standard for free and will use 14 periods by default. Most traders do not change the default settings of 14 periods. You can also change the overbought and oversold levels of 70 and 30. I personally DO change these depending on the trend of the market. If we are ranging then I stick to 70 and 30. When we are trending up I use 80 and 40. If we are trending down I use 60 and 20. I decide my trend based on the daily chart or the H4 chart. I most often trade RSI on the 30 minute chart and the 15 minute chart. But this is my own personal preference.
Depending on the market and depending on your trading style, you may wish to change the RSI indicator periods. The higher the number of periods you choose, the less frequently you will receive a signal (but the more accurate the signal will be) and the lower number of periods you choose, the more frequently you will receive a signal but the less accurate the signal will be. You have many options for the number of periods, but other RSI periods would be 9, 13, 21, 25 and 34.
The best time frame for RSI can be the one hour chart. But this opinion would create debate among most trading communities.