The RSI (Relative Strength Index) is a technical oscillator telling us how strong the price action is.
Developed by J. Welles Wilder in the 1970s, it is the most widely used indicator by technical analysts and traders.
RSI = 100 – [100/(1+H/B)]
H is the average of the value increase over the period considered
B is the average of the decrease in value over the period considered
The basic setting for all trading platforms is 14 periods: if you look at the 1-hour chart, the RSI value will give you the average of the last 14 hours.
Settings for 9 periods (more dynamic) or 25 periods (slower) are also often used. It is up to you to configure your RSI in such a way that it fits into your trading.
Use of the RSI
The RSI is a so-called’ ‘bounded” indicator, which means that its values are limited to between 0 and 100.
When the RSI is set to 50, it means an equilibrium zone depending on the unit of time you are trading.
When the RSI is lower than 30, the value is said to be “oversold”.
When the RSI is higher than 70, the value is said to be ”overbought”.
Thus, when prices are outside these two limits, price tends to quickly extract themselves from them, which gives rise to certain trading strategies.
This is not a certainty and during the trend phase, the RSI may remain a long period below 30 or above 70 and that is why it is not advisable to trade only on an RSI value.
Example of RSI below 30: the value rebounded, then the downward trend continued.
The essential aspect of this indicator is that it shows the strength of price movements, and especially the exhaustion of the strength of price movements. This creates divergences that are extremely reliable with the RSI but can be used on any type of indicator.
We will discuss the divergences in a later section.
Example of the use of the RSI: a bullish regular divergence in the oversold zone (below 30). This gave us an indication of a potential slowdown in the strength of the bearish movement.
Trading strategy with the RSI
Some traders, especially short-term traders, use the RSI to enter positions:
- Buy when the RSI is oversold and crosses the value 30 upwards
- Sale when the RSI is overbought and crosses the 70 value downward
Of course, the settings must be changed according to the type of trader you are.
Example of RSI settings
|Short term||Medium term||Long term|
However, I recommend using the basic setting for 14 periods with an overbought zone at 70 and an oversold zone at 30 because these are the most commonly used settings. And if many traders and technical analysts use the basic setting, then it is the one that will have the greatest impact on the future evolution of prices since it is through it that the entry and exit of positions will take place.
We talk about a self-directed event: all the traders use it because everyone thinks it works, and act accordingly. And since it really works, everyone keeps using it and watches it. Once again, it’s just psychology.
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