The Relative Strength Index (RSI) is one of the most well known trading indicators in the world.
It's available on almost all trading platforms and is used by professional traders.
So if you want to learn more about how to trade with this indicator, this tutorial will give you the history of the strategy, how it's calculated and trading strategies that utilize the RSI.
Alright, let's get into it!
Brief History of the RSI Indicator Creator
Before we jump into the details of the indicator itself, here's a quick background on the creator of the RSI, because it's an interesting story.
J. Welles Wilder Jr. was born in 1935 in Norris, Texas.
He attended North Carolina State University, where he studied mechanical engineering.
After graduating, Wilder served in the United States Air Force as a fighter pilot.
Wilder became a mechanical engineer, then a real estate developer. He later became intrigued by technical analysis in the financial markets.
In 1978, he published his groundbreaking book “New Concepts in Technical Trading Systems.”
This book introduced the Relative Strength Index (RSI) along with other technical indicators such as the Average True Range (ATR) and the Parabolic SAR (Stop and Reverse).
The RSI quickly gained popularity among traders and investors for its ability to identify overbought and oversold conditions in financial markets.
Wilder's contributions to technical analysis revolutionized the way traders analyze markets and make trading decisions.
Throughout his career, Wilder continued to develop and refine trading indicators and systems.
He also founded the Delta Society International, an organization dedicated to the study and application of technical analysis in trading.
The Delta Phenomenon is one of Wilder's most interesting books. In it, he shares his research indicating that all markets have a hidden order.
Wilder's innovative work in technical analysis earned him widespread recognition and accolades within the financial industry.
He passed away in 2021, leaving behind a lasting legacy as a pioneer in the field of technical trading.
Now that you know a little about the creator, let's take a look at the indicator itself.
The Core Principles of the Relative Strength Index
Traders use the RSI to identify potential trend reversals and confirm the strength of a prevailing trend.
It can potentially be used in any trading market, but must always be backtested before trading real money.
Extreme RSI readings can signal potential buying or selling opportunities, as they suggest that a market may be overextended and due for a correction.
Additionally, divergences between price movements and RSI values can provide insight into underlying market dynamics and potential changes in momentum.
Key components of the RSI include:
- RSI Formula: The RSI is calculated using a two-part formula, which is explained in detail below.
- Overbought & Oversold Thresholds: The default settings are 70 (overbought) and 30 (oversold) as potential signals for price reversals. However, these settings can be changed to generate fewer signals (greater than 70 and less than 30), or more signals (less than 70 and greater than 30).
- Divergence: When the RSI diverges from the current price trend, it indicates that the current trend may be weakening.
- RSI Periods: By default, the RSI is typically set to a period of 14. However, this can be adjusted to increase sensitivity (with a lower period) or decrease it (with a higher period).
The RSI is usually beneficial when used in conjunction with other technical analysis tools.
Here's what the RSI looks like on a chart:
RSI Strengths
- Since most markets usually trade in ranges, the RSI can be a good tool for taking advantage of reversal moves within a range
- The indicator is easy to understand
- This indicator is widely available
RSI Weaknesses
- The RSI can create many false signals in a strongly trending market
- An overbought or oversold signal does not guarantee that the market will reverse
- Like any other indicator or trading strategy, it takes time to master and needs to be backtested before using
Where to Get the RSI Indicator
The RSI is available on most charting platforms.
In fact, all of the charting platforms I've used had the RSI.
I would recommend using the RSI on TradingView, but use whatever charting software works for you.
How to Get RSI Alerts
If you don't have time to monitor the markets, then a platform that has RSI alerts is very valuable.
They will send alerts to your phone so you don't miss a signal.
Some platforms require you to install a custom indicator, while other platforms have alert capabilities built in.
That's why I recommend using TradingView.
It has RSI alerts built in.
Another way that you can get alerts is to use my custom indicator for MetaTrader 4.
Other platforms also have solutions, so find out what's available on your favorite trading platform.
RSI Trading Strategies
There are several ways to use the RSI to trade.
I'll be covering each method in more detail in future articles and I'll also backtest as many strategies as possible.
Here's a list of the common trading strategies that use the RSI:
- Overbought/oversold
- RSI Divergence
- RSI exit strategy
- Connors RSI 2
- Midline crosses
- Swing 5
You can learn more about each variation in this tutorial.
Now let's take a closer look at the RSI calculation.
RSI Indicator Calculation
The way that RSI is explained in most books and on most websites is a little confusing.
So I created a graphic that clears up the confusion and shows you exactly how the RSI calculation formula works.
Alright, now that you know the formula, let's break down each component.
First, let's start with the variables.
Number of Periods (n) or Length
n is one of the settings that you would use in charting platforms like TradingView, NakedMarkets or MetaTrader.
It's basically the number of periods that you want to look back on the chart to determine the current RSI value.
The default value is usually 14 periods, but it can be changed, according to what you want to achieve.
When the RSI is set to 14, your charting software will calculate the current RSI value based on the last 14 periods.
Many websites refer to the default RSI setting as 14 days, but that's only if you are trading on the daily chart. The RSI look back can also be measured in weeks, hours or minutes.
It just depends on what timeframe chart you are using the indicator on.
Therefore, I will refer to the RSI look back setting in periods, which is more accurate.
Your RSI period setting will depend on your goals and your trading strategy.
There's no right or wrong answer here.
It just depends on what you have tested and what is profitable for you.
Relative Strength (RS) First Data Point
The raw Relative Strength number simply shows you how current price compares to historical prices over the last n periods.
It can be a little tough to understand what that number is actually telling you.
So Wilder's formula turns the number into an index that stays between zero and 100.
Therefore, the RSI is an oscillator because it goes back and forth on a fixed scale between 0 and 100.
Having a set scale allows RSI to be easily used across any trading instrument.
It's also a momentum indicator because its goal is to show traders when momentum could be slowing down.
The first RSI graph point is calculated by summing the up periods and dividing the result by the n periods setting in the RSI indicator.
That number is then divided by the average of the down periods over the last n periods.
For example, let's say that you are trading the daily chart and n is set to 5.
The last 5 days are as follows:
- 10 pips up
- 20 pips down
- 100 pips up
- 30 pips down
- 200 pips up
In order to calculate the numerator, you would average the up days: 10 + 100 + 200 = 310 / 5 = 62
Then you would calculate the denominator with the down days: 20 + 30 = 50 / 5 = 10
Finally, you would divide the numbers to get: 62 / 10 = 6.2
Therefore: RS = 6.2
Converting RS into RSI
From there, you would turn RS into RSI by doing the following.
So starting from the right side of the equation: 100 / (1+ 6.2) = 13.8
Then: 100 – 13.8 = 86.2
Which means: RSI = 86.2
Subsequent RS Calculations
After the first RSI data point, all of the following data points are calculated with this modified formula.
This formula is similar to an exponential or weighted moving average, in that it gives more weight (importance) to the current RS reading.
So you would start by averaging the first n-1 periods for both up and down moves.
Then you would add in the current average for up and down moves to their respective averages and divide each total by n.
Let's use the data from the previous example and add in a 6th period, to show you how this works.
- 10 pips up
- 20 pips down
- 100 pips up
- 30 pips down
- 200 pips up
- 30 pips down
First, you would average the first 5 (n-1) up periods:
100 + 200 = 300 / 5 = 60
Then you would multiply the average by n-1 or 5:
60 * 5 = 300
Now we do the same for the denominator:
20 + 30 = 50 / 5 = 10 10 * 5 = 50
Next, average the data from the previous 5 periods, plus the 6th period.
Since the 6th period is a down period, nothing would be added to the up periods calculation:
300 + 0 = 300 / 6 = 50
Add in the 6th period down move, then average by 6:
20 + 30 + 30 = 80 / 6 = 13.3
Then RS is:
50 / 13.3 = 3.75
RS = 3.75
Converting RS into RSI
Again, we do the RSI calculation to convert the RS to RSI:
100 / (1+3.75) = 21 100 – 21 = 79
RSI = 79
RSI Signal Levels
As mentioned above, the default signal levels are usually 30 and 70.
But some traders will use different settings, depending on what they want to achieve.
Other common settings are:
- 20/80
- 10/90
This is where to find the signal levels on a chart.
If the RSI is over 70, price is considered overbought and is a potential sell signal.
On the opposite side, when the RSI goes below 30, that's a potential buy.
The concept is simple, but it takes testing and practice to master.
Common RSI Misconceptions
A few websites will tell you that a longer look back period is more “accurate.”
This is simply not true.
A shorter look back period will make the RSI more sensitive, which can work well for certain trading strategies.
A longer period may work better for other strategies.
Always test your strategy with different RSI settings and find out what really works for you.
Never take anyone's word at face value, always test it for yourself.
Other people on the internet will tell you that the RSI is a lagging indicator, so it's not useful.
The bottom line is that professional traders use the RSI.
Larry Connors is one trader who is well known for developing RSI trading strategies and has published his research.
Final Thoughts on the RSI Indicator
So that's how to RSI works and what it can tell you about a market.
Like with any other indicator, it has strengths and weaknesses.
This indicator is not for everyone, but if you like the idea of using this indicator, you should certainly look into it.
Review the different trading strategies that use the RSI, pick your favorite, then start backtesting.
