Investing in the stock market can be a daunting and complicated task for even the most experienced investors. But with the help of the Relative Strength Index (RSI), you can use this single indicator to gain insight into market potential, spot overbought and oversold conditions, identify trend reversals and much more! Read on to learn how RSI can help make sense of the markets!
You can also read: What Is Price Action Trading? A Simple Definition To Get You Started
What is RSI(Relative Strength Index)?
Relative Strength Index, also known as RSI is a momentum oscillator that measures the amount of change and speed of the price. RSI oscillates between the range of 0 and 100. Traditionally, if the RSI shows a number above 70 it’s considered overbought and when it’s showing a number below 30 it’s considered oversold.
Trading signals can be generated by RSI if you look for failure swings and divergence in RSI oscillators. In this article, we’re going to learn how to look for divergence and how this helps us understand the story that the market is trying to tell us. But before that, we’re going to learn more about RSI and understand exactly how it can be useful for us.
According to J. Welles Wilder, developer of the Relative Strength Index oscillator, there are a few problems with indicators like the Moving Average. Now, before moving forward, let’s quickly go over what the moving average is.
Moving average is an indicator that shows us the average price of the market in a given time. For example, if the moving average is set to 7, it will show the average price of the market in the last 7 days.
Now, let’s move on. According to Wilder, there are 2 main problems with moving average indicator (it’s more of limitations than problems to be fair), the first one is that if the market price was around the same numbers and was in a rest phase for some days, a sudden change in the price will cause a great change in the moving average indicator.
Let’s say we have a moving average that’s been set on 7, if the price of the market was around 10 and 11 for 7 days, the moving average will show a number around 10.50. Now imagine that there has been a great change in the price and in a day the price is 15 all of a sudden. Moving average’s line will start inclining with a great slope.
To put it shortly, after some time that the price was not moving or was only moving in a very small range, a sudden big change in the price will cause a great change in what the moving average is showing us.
To fix this problem we need a filter to help stop these sudden changes to affect the data and so the different parts of the data will be more united and more connected. You guessed correctly, the relative strength index is that filter.
Another problem with the moving average is that it doesn’t move in a fixed space or fixed range of numbers. It will simply move with the market price and we all know how volatile the market price can be. There are some times that the moving average is moving in a fixed space and that’s when the market is in a trading range and constantly moving between a support line and a resistance line. As soon as the price breaks out of the trading range, the moving average won’t be moving between a fixed range of numbers anymore.
RSI naturally fixes this problem as the oscillator moves between a fixed range of 0 to 100.
RSI moves between a fixed range between 0 and 100. When RSI is showing a number above 70, it means that the market is in a phase where traders are buying based on emotions and they’re getting greedy, so the market is overbought.
When RSI is showing a number between 30, it means that the traders are selling based on emotions, and that emotion is fear. The market is fearful, thus it’s oversold.
As a general rule, the overbought zone is great to sell and the oversold zone is great to start buying. But it depends on what your strategy is, how much are you going to stay in the market etc.
Now you have to remember that if RSI shows that the market is overbought, it doesn’t necessarily mean that it’s going to start dropping right away, it may start declining right away but it also could take some time. So do not enter or exit the market based only on RSI being overbought or oversold. Instead look at the first time RSI enters the overbought zone as a warning, just don’t act based on it.
So, let’s start and find out how we can find RSI divergence and how we can use them to generate trading signals.
When the market is in an uptrend but RSI failed to get to new highs and creates a high below the last high and vice versa, when the market is in a downtrend and the RSI failed to get to new lows and creates a low higher than the last low, it’s a divergence.
To put it simply, an RSI divergence is when the price action and RSI indicator are no longer in sync.
In this image, you can see that also in the price action we have a higher high and bitcoin went up from around 56000 to 64000, but if you look at the RSI you’ll see that it’s actually a lower high shown by RSI, that’s a divergence.
If you spot a divergence it shows that the market is losing momentum and a reversal in the trend is possible. To put it simply, a divergence is when the price action and the RSI are not agreeing with each other and have different opinions.
But a divergence doesn’t always mean that the price is going to drop, it can sometimes mean the opposite, that the downtrend is possibly over and a new bullish trend could be beginning. Divergence can be bullish or bearish.
Here’s a cheat sheet that wolfofallstreets provided that will help you figure out what type of divergence we are dealing with and what does it mean for us.
A bullish divergence is when the RSI indicator is in the oversold zone, then a higher low. This is in correlation to the price action which is in a downtrend and has made a new low. Then, it makes a new lower low.
In a hidden bullish divergence, it’s a bit different, the RSI indicator is in the oversold area, then it makes a new lower low. Price action tells a different story tho. After making a new low in a downtrend, it has now made a new low which is higher than the low before.
In a bearish divergence, the RSI is indicating that the price is in the overbought zone, then, it makes a new high which is lower than the high before. Price action on the other hand is in an uptrend and has made a new high, then it makes a new high, higher than the high before.
In a hidden bearish divergence, the RSI read is telling us that the market is in the overbought area, then it makes a new higher high. The price action tho, after making a new higher high in an uptrend, makes a new high that is lower than the high before.
You don’t need to try and memories the divergence cheat sheet. It won’t serve you any good. Instead, understand and find relations between them and try to find them. Try finding different types of divergences on a chart so you can understand them better.
A good method you can use to understand and distinguish between the bearish and the bullish divergence is that you should see what’s making the divergence. It means whether it’s a divergence in lows or highs.
If the market is in an uptrend, the divergence is most likely in the highs, meaning the highs made in the price action doesn’t match the highs indicated by RSI.
If the market is in a downtrend the divergence is very probably in the lows. Meaning the lows in the price action aren’t in sync with the lows read in RSI.
Relative Strength Index (RSI) is a great tool that can help us understand the market better. It is one of my favourite indicators and has helped me a lot before as I’m sure it will do too in the future. And I’m sure by understanding the RSI and after you got comfortable using it, you will find it very useful as well.