Relative Strength Index, with its widely known short name RSI, is an oscillator indicator for technical analysis. Traders use lots of different analysis methods, both technical and fundamental. RSI is one of the most known and used indicators. Despite its wide adoption, it is still a very useful and successful oscillator.
RSI is created by legendary technical analyst J. Welles Wilder. It calculates the current strength of the price relative to the calculation period. The calculation is very basic and can be easily studied with a program like Excel. Calculation steps can be summarized below:
- Average gain: Average of all up bars in the calculation period.
- Average loss: Average of all down bars in the calculation period.
- RS = average gain / average loss.
After calculating RS (relative strength), RS turned to an index to fit all charts.
- RSI = 100-(100/(1+RS))
How to Use the RSI Indicator
The relative strength index is mostly known for its “overbought” and “oversold” signal, which shows the price rose too quickly or fell too sharply relative to the calculation period. But RSI can be used in lots of different ways. In this article, we examine a few of them to give you some ideas so you can use them or develop them as you wish.
Overbought and Oversold
RSI index shows the recent strenght of the price in the 0 to 100 range. If the up or down moves came too fast relative to the calculation period which is 14 by default, it gave you an overbought or oversold signal. These signals, like any indicator in technical analysis, are not too accurate but are relatively successful among most of the used indicators, especially in ranging charts. These signals, like any indicator in technical analysis are not too accurate. However, they are relatively succesful among other indicators, especially in ranging charts.
The chart above is showing the Gold price, roughly for one and a half years. Gold is ranging between 1675 and 2080 throughout the chart which provides a good example for RSI’s overbought and oversold use.
30 and 70 are accepted as limits and above 70 is the overbought zone while below 30 is the oversold zone. There are 5 oversold and 3 overbought signals that came during the period. Some of them start a short trend and some of them cause a mild correction. The time to buy and sell can be wary between traders, but perhaps the most correct one is not getting in a trade at exactly the same time as the signal came, but rather wait for a reversal. This means, that when RSI is past 70 to above, the up move might continue for a while. When its strength starts to weaken and the RSI fall below 70 might be a good time to sell. Same as the buy signal, after crossing 30 to above, it might be a good time to buy.
Positive and Negative Divergence
The markets do not always range in a flat zone but trend up or down. The relative strength index’s overbought and oversold signals might not work very well during that times but it is calculating the strength of the trend rather than the price. During those times, the divergences with the price show the strength of the trend and signals that the “trend reversal might be coming soon.”. In the example, S&P 500’s CFD chart shows both positive and negative divergence.
Negative Divergence: During an uptrend, while the price continues to make higher highs, if RSI makes lower highs at the same time, it is called a negative divergence, which signals a selling opportunity.
Positive Divergence: During a downtrend, while the price continues to make lower lows, if RSI makes higher lows at the same time, it is called a positive divergence, which signals a buying opportunity.
Divergence is not a direct buy or sell signal. Higher highs in a negative divergence or lower lows in a positive divergence might exceed four. The timing of the position entry is difficult. Trend lines, supports, resistances or other indicators can be used to minimize the risk of a bad entry.
RSI might be used to confirm the continuation of an existing trend to enter a trade in the direction of the trend. With no clear divergence in sight, a reversal from the overbought zone for downtrends and a reversal from the oversold zone for uptrends can be a good signal for the trend to continue.
Under or Over 50
A different and less known way to use the relative strength index is over and under the middle point, 50. While the price is trending, over 50 RSI shows a strong upward trend. Crossing under 50 means the trend’s momentum is ending and bears start to take control. As long as RSI stays below 50, a downtrend is expected to form, as crossing over 50 might be a sign of trend reversal.
50 does not always act as support and resistance so this use of RSI is somewhat rarer. But when formed like the Apple example above, it gives very good trade entry and exit points.
Moving Average Cross
Crossing 50 does not always give good signals; sometimes, these signals come very late. An alternative way is using a moving average. When RSI crosses above its moving average, that means a buy signal. When RSI crosses under its moving average, it means a sell signal. Ranging with sharp reversal or trending markets gave relatively good results while trends with low slopes and tight-ranging markets often give lots of false signals.
Weak Points of the RSI
Like all of the indicators, the relative strength index also has many weaknesses. We discussed each of these weak points briefly in the “how to use the RSI indicator” section. But seeing a concrete example might be better for understanding.
In the example above, USDJPY is trending aggressively. Because of the FED’s tightening steps while BOJ (Bank of Japan) keeps its extra loose monetary policy, the uptrend has a lot of fuel to keep going north. Because of the extreme fundamental pressure, RSI’s overbought signals became obsolete.
If you read the divergence section, you know divergence gives better results for trendy markets. But despite RSI’s downtrend and massive negative divergence, USDJPY continues to push up. Perhaps an over 50 approach can be used, but it also gives lots of fake signals.
Different uses of RSI give different results in many securities and many different markets. But when there is a big fundamental gap to be filled in, most of the indicators give lots of false positive signals and it is better to stay careful about these extreme situations.
A Basic Backtest Example for RSI
Indicators have a lot of different using styles. It is wise to choose the best one for the situation or create your way. In this example below, we test the most basic use of RSI, below 30 and above 70 reversals. It is calculated for EURUSD and XAUUSD for the last 5 years.
Buy and Hold: When RSI crosses 30 to above, the system will buy and hold until a sell signal comes.
Sell and Hold: When RSI crosses 70 to below, the system will sell and hold until a buy signal comes.
Gold had one major uptrend in the last five years. All of the other times it has ranged in two wide and flat zones. The backtest gave 6 long and 6 short signals with a total of %36.26 profit and a %31.11 maximum drawdown. The big drawdown came with the trending period and most of the profit came from the ranging period as expected. Only 3 of the 12 trades end up in a loss.
EURUSD has an extremely tight, low slope trend and another 2 major, high slope trends. Because of having almost no flat period, only 4 signals came and only one of them was profitable. The total loss is %27.66 and the maximum drawdown is 28.03
RSI is a widely adopted and highly adaptable indicator that can give successful signals to almost any market depending on its timely and correct uses. Of course, it has many weaknesses like all the indicators used in technical analysis. But combined with other indicators and chart patterns, RSI can be a powerful tool for any trader, both for new and experienced ones.