Technical Analysis Series — Article #5: Introduction to the Relative Strength Index (RSI)
What is the Relative Strength Index and How Do I Use It?
Developed by J. Welles Wilder, the Relative Strength Index (RSI) is used by traders in combination with other tools to determine when an asset is overbought or oversold. By default, the momentum indicator has two important levels, one indicating that it is overbought and may correct to the downside when it is above 70, and the other indicating that it is oversold and may bounce to the upside when it is below 30. There are two primary ways this indicator can be used. The first type is purely based on assessing if an asset is oversold in order to buy, or overbought in order to sell. The second type is based on divergences. An example of this is when price action is rising while the RSI is lowering, giving a sell signal.
The infographic above is a cheat sheet to help you look at the most common divergences that occur between an indicator and price action, and what they typically mean for trading. Let’s look at some examples of the RSI being used in a trade.
Examples
In Gold (XAUUSD) on the weekly, we see a bullish divergence occuring. As price action went down, the RSI went up. By placing a Fibonacci retracement on a corrective structure, (the Fibonacci retracement placed here is placed on a corrective structure, instead of a trend — this follows Elliott Wave Theory) we see the price action bounce off perfectly at the 1.618 level. Paired with the divergence, you could have bought at this level.
In Bitcoin (BTCUSD) on the weekly, we see two trade different trade setups.
On the first one occurring at an earlier time, a bearish divergence occurs with price action rising, but the RSI lowering. By placing a Fibonacci retracement, we look at the 1.272 Fibonacci level and see if price action rebounds at that level. Once it started to rebound, you could have sold this level to catch a maximum of a 35% price decrease.
The second setup consists of the same idea with the bearish divergence and looking for a Fibonacci level at which price action would start to rebound (in this case it was the 2.618 level).
In Apple (AAPL) on the weekly, we see the RSI enter the oversold level. As this was a point at which a correction occurred, buying when the RSI went into the oversold would have allowed you to buy near the bottom.
In the S&P 500 (SPX) on the weekly, we see two trade different trade setups.
The first one is with the RSI heavily extending into the overbought level, giving you a warning that a correction may occur.
The second setup is a bearish divergence occurring with price action rising, but the RSI lowering. By placing a Fibonacci retracement, we could look for some levels from which price action may rebound. In this case it was near the 1.272 Fibonacci level, before another major dip occurred.
In the S&P 500 (SPX) on the monthly, we see the RSI enter the oversold level twice. As these were during a correction, buying when the RSI went into the oversold would have allowed you to buy near the bottom.
In Bitcoin (BTCUSD) on the weekly, we see the RSI enter the oversold level. Since this was when a correction occurred, buying when the RSI went into the oversold would have allowed you to buy near the bottom.
Sounds Easy?
Don’t be fooled. Trading is not as easy as this, and is a discipline that requires extensive learning. The truth is that 90% of traders lose money. However, with proper training and money management, you are able to be in the 10% that do not. Always have a trading plan, use stop-losses to cut your losses and move on, and never overtrade.
This is the author’s perspective and is meant to be used for educational purposes. This is not financial advice.
Written by Fahim Ahmed, Writer for the Junior Economist
Originally published on November 29th, 2019
