3 June 2020 | AtoZ Markets - The RSI indicator is known as a momentum oscillator. It shows directional price movement by measuring the force and enormity. The value of the ups and downs in the price is called momentum. The momentum is the ratio of higher closes to lower closes that is calculated by the RSI.
Higher RSI occurred when the stock had stronger positive shifts. Besides, stocks that had powerful negative changes had lower RSI.
What Is the RSI Indicator?
Momentum indicator in the technical analysis used to measure the spread or expansion of current price changes to appraise the overbought or oversold situation in stock or asset price is known as the relative strength index (RSI). RSI is a line graph that moves between two extremes (oscillator). It can have a reading 0-100. J. Welles Wilder Jr. created the indicator and published in his seminal 1978 book named "New Concepts in Technical Trading Systems."
According to conventional meaning, when the asset becomes overvalue the RSI values of 70 or up. It also may instruct a trend shift or drawback amendment in price. RSI reading 30 or below is the signal oversold or undervalued situation.
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How Does the RSI Indicator Work?
When the RSI line is above 70, it considers as an overbought and when the line below 30 it considers as an oversold. These levels gave on the trading platform as a default setup, which can be changed as the user's choice. Like, if the asset price, again and again, touching the overbought level 70 you may adjust this level to 80.
It should be noted, during the impulsive trend momentum, the RSI line may reside overbought and oversold for a long period. Moreover, sometimes RSI indicator forms a chart pattern that may not be visible on the price chart. Moreover, RSI 30 to 70 default ranges may change, relying on RSI settings and the capacity of the security trend.
Calculation of RSI
For better understanding, RSI has divided into its basic components, Mean Gain and Mean Loss. The calculation of RSI set on 14 periods, which is a default setting. Positive values indicate losses, not negative values.
The simple 14-period mean is the first calculation for mean profit and mean loss:
- Sum of Gains of the past 14 periods, divided by the 14 = First mean profit
- Sum of losses of the past 14 periods, divided by the 14 = Frist mean loss
The previous mean and the loss of the current gains are the second calculation:
- [(Previous Mean Profit) * 13 + current Profit] divided by 14 = Mean profit
- [(Previous Mean Loss) * 13 + current Loss] divided by 14 = Mean Loss
Adding previous value together with the current value is an easing method, which used to calculate the Exponential Moving Average (EMA). With the extension of the calculation period, RSI values become more effective. When RSI values are calculated, it calculates 250 data points of the previous starting date of any chart. The method needs at least 250 data points to replicate the RSI numbers.
RS becomes conventional and switches into an oscillator through Wilder's formula. Then the oscillator fluctuates interim zero and 100. As a matter of fact, RS plot and RSI plot both are looks similar. RSI is range-bound, that makes it easier to recognize the extremes through the normalization procedure. RSI comes zero when the Mean Profit equals to zero.
A zero RSI value means all 14 periods prices shifted lower and weren't any gain to measure, pretending a 14-period RSI. RSI is 100 against the Mean Loss equals zero. It means all 14 periods prices shifted higher without any losses to measure.
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RSI Trading Strategies
There are plenty of RSI trading strategies, which is used by professionals to take the opportunities of the overbought and oversold situation in a particular market. Some of them use RSI by customizing its period, combine it with other trading indicators, divergence trading, and even following the trend line of RSI.
Each strategy generates a unique tool that qualifies various strategies. You need to understand the basic of RSI indicator since you leap on any strategies. These trading strategies are not Faithful until you practice it over and over and become a master on it.
RSI Overbought and Oversold Trading Strategy
RSI overbought and oversold strategy is the simplest method to trade the market. It bases on the theory that when the market is overbought look for sell entry and when the market is oversold look for a buy entry. We will use the RSI indicator to understand the market price action, besides the 20 Exponential Moving Average (EMA) to confirm the trade entry.
Buy Entry
Firstly look for RSI line come to below the oversold level 30 and moved up. Secondly, look for the price to break above the dynamic level of 20 EMA with an impulsive bullish close. Then take a buy entry, and your stop loss should be below the lower low with ten pips buffer. Take the profit when the RSI line reaches the overbought level 70.
Sell Entry
Firstly look for RSI line come to above the overbought level 70 and push down. Secondly, look for the price to break below the dynamic level of 20 EMA with an impulsive bearish close. Then take a sell entry, and your stop loss should be above the higher high with ten pips buffer. Take the profit when the RSI line reaches the oversold level 30.
RSI Trend Following Strategy
RSI trend following strategy is the most well-known trading method, which is widely used by the professionals to ride the trend. Trend riding is the most common method to gain a massive amount of pips. We will use only the RSI indicator to ride the trend.
Buy Entry
For Buy Entry, look for RSI line indicating oversold and making new higher high by following the trend line. Enter a buy trade when the price bounces from the trend line, your stop loss should be below the lower low or recent higher low with ten pips buffer. Take the profit when RSI indicates that the market is overbought.
Sell Entry
For Sell Entry, look for the RSI line indicating overbought and making new lower low by following the trend line. Enter a sell trade when the price rejects from the trend line, your stop loss should be above the higher high or recent lower high with ten pips buffer. Take the profit when RSI indicates that the market is oversold.
RSI Divergence Trading Strategy
RSI divergence trading strategy is the most powerful trading method with higher accuracy ratio. We may see these types of market structure very often, but it's the most effective trading strategy, which is used by professionals.
Buy Entry
For buy entry, look for the price to make lower lows, at the same time RSI line making a double bottom on the oversold level 30. Enter a buy trade when the price creates an impulsive bullish candle. Your stop-loss should be below the entry candle with a buffer. The buffer may vary according to the price action or timeframe. Take the profit when the RSI line reaches on the overbought level 70.
Sell Entry
For sell entry, look for the price to make a higher high, at the same time RSI line making a double top on the overbought level 70. Enter the sell trade when the price creates an impulsive bearish candle. Your stop-loss should be above the entry candle with a buffer. The buffer may vary according to the price action of the timeframe. Take the profit when the RSI line reaches on the oversold level 30.
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Conclusion
- The RSI is a momentum indicator.
- RSI provides overbought and oversold signals.
- Above 70 considered as bullish.
- Below 30 considered as bearish.
- Always use the Stop-loss.
- For better signal, RSI can be combined with other indicators.
It's not hard to find Faithful trading setups using RSI, but the main challenge is how you maintain your psychology with these trading strategies.
Should you use the RSI trading strategies on your own at all?
Before you start using the RSI trading strategies, you'll want to read this.
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