The Relative Strength Index
(RSI)
The RSI indicator is a popular momentum oscillator developed by J. Welles Wilder Jr. originally for trading commodities. The recommended setting by its developer is 14-period, which is the default setting in most platforms. An RSI value of 30 and below is considered to be oversold, while an RSI value of 70 and above is considered overbought.
However, a much better way to interpret the RSI value is through momentum. If the value stay around and above 70 RSI, it is a sign of strength in momentum to the upside. The price of the instrument is likely trending upwards. Likewise, if the value stays around and below 30 RSI, it is a sign of strength in momentum to the downside. It is likely trending downwards. Depending on the market condition, this attribute of the RSI can be used to effectively execute trades.
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The formula for RSI is as follows:
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RSI = 100 - [100 / (1 + (U/D))]
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U = average of upward price closes (EMA of gains)
D = average of downward price closes (EMA of losses)
Ways to Trade with RSI:
There are two main ways to trade effectively using the RSI.
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The first method is through the oversold/overbought signals. This strategy is simply buying when it’s oversold (30 RSI), and selling when overbought (70 RSI). This type of trading is most effective during a consolidation phase, or when the market is trading sideways. During a sideways market, momentum is weak and prices oscillate a lot more often. Therefore, when the RSI reaches its extreme zones, the price is a lot more likely to quickly change direction.
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The second method and my preferred method is through RSI divergence. RSI divergence is when the trends of the price action and the RSI begin to move in opposite directions. In my opinion, this is the most potent use of the RSI indicator.