This article on Relative Strength Index / RSI Trading is the opinion of Optimus Futures.
When the trajectory of a price swing is upward, typically day traders assume there’s an influx of buyers powering the asset, that is bidding up its price. Conversely, when asset prices are falling, we assume that there are more sellers than buyers; the latter demanding lower prices.
In this bidding process, is there a way to measure whether prices are moving toward “overbought” or “oversold” levels before a stall or reversal takes place?
That is what the Relative Strength Index (RSI) is designed to try and indicate.
The RSI measures the speed and size of price movement, indicating when prices may be overbought or oversold and potentially ready to stall or reverse.
There are many ways to use the RSI. Although each way won’t necessarily fit every trading scenario, it’s a tool we feel that every trader should have in his or her toolbox.
What is Relative Strength Index (RSI) in Trading?
When it comes to oscillators, the Relative Strength Index is one of the most widely used momentum indicators.
First introduced by J. Welles Wilder in his book New Concepts in Technical Trading Systems, published in 1978, the RSI measures the strength of an asset’s price against its price change history, comparing “up” days to “down” days.
This may sound a bit complicated, but its end goal is more simple.
RSI tries to estimate whether prices are moving too high or too low, relatively speaking, compared to an underlying assets price history.
How is the RSI Constructed?
To construct the RSI, several calculations must be made. The basic RSI uses a 14-day period, which was the one developed by Wilder:
1 – The first step is to calculate the RSI for the initial 14-day as follows
RSI = 100 – (100 / (1 + RS))
Where RS = UPS/DOWN
UPS = Average gains over N period
DOWNS = Average losses over N period
2 – After calculating the RSI for the first 14 days, a smoothing method is used for future days. For days 15 and after
UPS (day i) = [(UPS (day i-1)*13) + Gain (day i] / 14
DOWN (day i) = [(UPS (day i-1)*13) + Gain (day i] / 14
The RSI is plotted beneath the price chart, ranging from 0 to 100.
Most analysts consider a reading above 70 to indicate overbought levels, while a reading below 30 for most analysts indicates oversold levels.
Depending on how strict the trader wants to be, these thresholds can be changed based on an individuals unique perceptions.
ES – Daily – 9.26.22 to 11.22.22 (Source: Optimus Flow)
Here’s an important principle: The tighter confidence intervals are set, the fewer signals you will receive using RSI, these signals however should be more reliable when they are provided.
Another important principle: The characteristic of the market, whether it is trending or sideways, will also affect the RSI. These types of markets often don’t exhibit momentum or directional patterns for RSI to consider accurately.
For example, an oversold level in an upward-trending market may not always approach the lower band of 30, as the upward momentum can sometimes overwhelm the selling pressure.
MYM – Daily – 5.5.22 – 8.16.22 (Source: Optimus Flow)
Notice how the oversold levels correspond with pullbacks before prices resume the next leg up.
In a non-trending scenario, the RSI gives us a different type of reading.
MGC – Daily – 8.24.22 – 11.22.22 (Source: Optimus Flow)
Notice here that the overbought (above 70) and oversold (below 30) levels correspond with support and resistance in a range-bound market.
It’s important to distinguish between these two conditions to avoid making the wrong entry in a market you’ve misinterpreted. When using RSI traders should have a good concept of the type of market they are evaluating.
How Do Traders Use RSI?
Long-Term Turning Points
Most long-term traders and investors use the oscillator in its most simple form: they sell when the asset crosses into overbought territory and they buy when it enters into oversold territory.
This might work better when viewing a long-term chart, but it can be risky.
- If the market is trending up, a reading below 30 indicates a potential buy signal.
- If the market is trending down, a reading above 70 indicates a potential sell-short signal.
Note that the RSI can stay in the overbought or oversold region for an extended period, so be careful not to jump into a trade too early.
In this case, we’d advise using additional indicators or signals to fine-tune your market entries.
Gauging Trend Strength
Another way that the RSI may be used is to determine the trend. Indeed, some view a reading above 50 to mean that the market is in an uptrend and a reading below 50 as being in a downtrend and take their positions accordingly.
While this is not an advanced method, it’s simple and practical, plus it could be useful for weekly and monthly charts.
A trader could buy on a clear break above the 50 level and remain long until a clear downward break below that level.
MYM – Daily – 9.22.22 – 11.22.22 (Source: Optimus Flow)
Here are a few more ways to use the RSI, based on J. Welles Wilder himself:
Divergence – A Key Indicator: When you see a divergence between a price swing and an RSI reading, it strongly indicates that a reversal is imminent.
For instance, if prices rise while the RSI is trending down, be ready for a pullback.
Conversely, if prices continue to trend down while the RSI begins to trend up, prepare for a bounce.
Tops and Bottoms: Anticipate “relative” topping or bottoming action when prices move above 70 and below 30, respectively.
Hidden Price Patterns: Chart patterns may appear on the RSI while remaining absent from the price chart. These can help you detect hidden price patterns that otherwise would have been missed.
Failure Swing Highs and Lows: If prices fail to swing higher while above the RSI’s 70 level, it’s likely bound for a pullback or reversal; conversely, if prices fail to make lower lows while below 30, prices are likely to bounce.
LEARN MORE | RSI Trading Strategies for Swing Traders & Day Traders
The Bottom Line
While no indicator can deliver forward-looking information that’s 100% accurate, the relative strength index is one tool that can be useful if you learn how to use it correctly.
It may not fit every trading scenario, but it can often deliver actionable information as a stand-alone tool for those that are looking to develop a technical trading approach.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
