Very popular with independent traders, the Relative Strength Index is an "off price" technical indicator that measures the strength of the current stock market trend. Used by day traders and swing traders alike, the RSI allows them to follow the evolution of bullish and bearish trends in order to detect overbought or oversold situations in which the market is overheating. A more detailed use of this indicator also allows traders to anticipate trend reversals thanks to the study of its "divergences".
What is the RSI ? How do you calculate the RSI ? How do you set it up correctly ? How do you interpret divergences? On which types of financial assets should it be used ?
Here is a complete summary of what you need to know to boost your trading performance through the proper use of the RSI indicator.
By definition, the Relative Strength Index is an "off-price" technical indicator, i.e. a mathematical formula whose results are presented visually just below the price chart. The RSI is a member of the oscillator category, ranging from 0 to 100. Developed for the first time by the American engineer J. Welles Wilder in 1978, in his book New Concepts in Technical Trading Systems, the RSI has now become one of the most widely used technical indicators by traders. Two key levels of the RSI, the 30's and the 70's, allow for the identification of bullish or bearish excesses of a current trend :
Like most technical indicators, the RSI depends on a parameter n corresponding to the number of periods considered for its calculation. If the trader uses a chart in "Minutes" time units, the RSI will be calculated on the last n minutes. If the trader uses a chart in time units "Hours", the RSI will be calculated on the last n hours. And so on... The RSI calculation formula is RSI = 100 - [100/(1+MP/MG)]
Let’s take the example of the CAC 40 stock market index in "Days" time units and a parameter n equal to 14. If over the last 14 sessions, 4 bullish sessions recorded an average performance of +2% while the 10 other stock market sessions recorded an average performance of -4%.
Calculation of the RSI RSI(14)= 100 - [100/(1+ 4%/2%)] = 66.67
Most traders use the RSI indicator on a 14-day timeframe. It is possible to modify this setting to adapt the behaviour of the indicator. Choosing a smaller number of periods allows the RSI to be more reactive and therefore to anticipate certain signals. Be careful, however, as this can lead to erratic behavior which then increases the risk of having false buy or sell signals. On the other hand, choosing a larger number of periods will smooth the RSI indicator to make it less sensitive to "market noise" and thus avoid false signals. But be careful not to enter a position too late...
The first way to interpret the RSI indicator is to simply study its absolute position to see if it is within :
When the RSI enters the overbought zone, traders will tend to take profits on long positions or look for possible reversal signals in order to bet on a price correction. Conversely, when the RSI enters the oversold zone, traders will tend to make profits on their short positions or look for possible reversal signals in order to bet on a price rebound. Other traders, however, will be interested in the signals sent by the RSI when it exits the overbought or oversold zones. There is no statistical evidence to support the best way to use the RSI indicator, so you will have to make up your own mind, always taking into account the market context.
Another way to interpret the RSI indicator is to detect the formation of supports or resistances, whether horizontal or oblique levels. The reflex of most traders is then to buy when the RSI is in contact with one of its supports, and to sell when the RSI is in contact with one of its resistances.
Finally, the RSI indicator is also very popular with traders looking for weak signals that could signal a trend reversal. A more detailed study can indeed detect possible divergences between the evolution of the RSI indicator and the evolution of prices. When a market continues to make new highs but the RSI is struggling to make new highs, or when prices make new lows but the RSI fails to make new lows, the trend is weakening. Such divergences can then alert the trader to the proximity of a trend reversal, allow him to take profits in time, or even offer him the opportunity of a high potential counter trend trade.
Whatever your use and interpretation of the RSI indicator, keep in mind that technical analysis is not a crystal ball, but just one of the tools available to traders.