RSI Indicator: How to Use it in the Right Way?

What is an RSI Indicator?

Before we deep dive into what is an RSI indicator or how to use it, it is crucial to understand what an oscillator and momentum are. This is because it is an oscillator and is based on the concept of momentum.

In the words of John J. Murphy, “Oscillator provides the technical trader with a tool that can enable him or her to profit from periodic sideways and trendless market environments.” Putting this in simple terms, the oscillator-based indicators work quite well when the price is not in any trend: neither an uptrend nor a downtrend, but works remarkably well when the price is just moving sideways in a range.

Unlike the Moving Average that trade analysts use during price-trending phases, an Oscillator works according to the band of the prices that a crypto or stock is moving in. Coming to momentum: it is the change at which some parameter changes. In the world of crypto and stocks, momentum is the rate at which the price of an asset is changing. 

It takes momentum into account and for doing so, it checks the difference in prices of crypto for a fixed time frame. Let us how that’s done. Momentum is calculated by a simple formula that calculates the difference in price of the crypto n days back and the last price (usually the closing price). So, the momentum becomes:

Momentum = Last Closing Price – Closing Price n number of days back. 

The aim of considering momentum in RSI indicator is to construct a momentum line. In the formula above, if the value of momentum comes out to be a positive value (The last Closing Price is more than the Closing Price n days back), a point on the momentum line is constructed above the zero line. If the momentum value is negative, the point is plotted below the zero line. Usually, for constructing momentum lines, short periods such as 5, 10, and 40 days are used. The shorter the period considered for the change in prices, the more sensitive the indicator based on it becomes.

So, by far, you know that it is an oscillator and is Momentum-based. Now, let’s study it in detail. The word “RSI” stands for Relative Strength Index. This could make you think that it measures the relative strength between two different cryptos or stocks.

But that is not true. In fact, it calculates the difference in the strength of prices of the same asset. By doing so, it takes into account the erratic movement of price ranging sideways; it does by creating a horizontal band of upper and lower momentum values.

We shall read more about how this oscillator is plotted later on. It measures the rate at which the price of a crypto asset changes. Being a momentum indicator, it primary function involves evaluating how strong the prices are during their up days in comparison to how strong they are on days when an asset price is down. This gives us an idea of the Relative Strength.

Let us have a look at the formula for Relative Strength:

Relative Strength (RS) = (Average of prices for the n days when prices closed higher/ Average of prices for the n days when prices closed lower)

The numerator above is calculated as:

Addition of all the Points gained up / number of days taken into consideration

And similarly, the denominator is calculated as:

Addition of all the Points gained down / the number of days taken into consideration

J. Welles Wilder Jr., who had developed it, took into account 14 days for the above formula. 

From this formula, we can calculate the value of RSI:

RSI = 100 – [100/(1+RS)]

How to Use RSI Indicator?

Plotting Upper and Lower Bands

As we had mentioned earlier, it works in upper and lower bands. It is usually plotted on a scale that works between 0 and 100. Most trade analysts however keep two other points into consideration while noting signals and these are 70 (overbought scenario) and 30 (oversold scenario). A crypto asset is said to be “overbought” if indicator line goes above 70 and is said to be “oversold” when it goes below 30. These are used by traders to predict buy and sell signals.

For example, you have an up position in an asset and if you notice that the price is going up for some time and you notice the it is in an overbought condition, i.e. oscillating above 70 but then it goes below but does not come back to above 70 region. This can indicate that the price trend is about to change and accordingly, you sell your asset to avoid losses. The reverse of this is also true: when RSI is ranging in oversold (below 30) region and prices are in a downtrend for some time; the indicator goes above 30 and does not come back to below 30; this may be the time for buying crypto assets. 

As you see above, like other oscillators, this is also plotted against the price chart to let traders compare the trends of the two and make the right decisions. At most of the points, the highs and lows of the price coincide with the peaks and troughs, but that is not always true; in such cases, some sort of divergence between the two might happen. We shall read more about divergence later in this article. 

As you can see in the chart above, it is a leading indicator; it shows the possible rise or decline in prices way ahead when the price actually rises or falls. 

Popular RSI Indicator Buy and Sell Signals

• As we saw earlier, when RSI is near or below 30, it can be seen as a signal for a bearish market. Conversely, when an asset is near 70 or above, it is considered a bullish signal.
  
• A Value above 70 indicates that the asset is overbought and may be headed toward a trend reversal to the downside. Conversely, an oversold signal below 30 may indicate a trend reversal towards the upside.
  
• Divergence Signals: A divergence means prices and RSI values diverge from one another, thus indicating a trend reversal in the near future. A Bullish Divergence is when the prices form lower lows (goes lower than its previous low) and RSI makes a higher low ( goes higher than its previous low). It is an indication of a trend reversal to the upside and could be considered a buy signal. A Bearish Divergence is when prices form higher highs but RSI makes a lower low. This may indicate a trend reversal to the bearish side (a sell signal). The following chart is an example of a Bearish Divergence. 

• Swing Failure Signals:
  
  Bullish Swing Failures (A trend reversal to the upside may happen) occur when these conditions are met: RSI goes into the below 30 range (oversold territory). It then goes back above 30. Again, makes a low but does not reach below 30 this time.Eventually makes a high that is higher than its previous high.
  
  Bearish Swing Failures (A trend reversal to the downside may happen) occur when these conditions are met: indicator goes into the above 70 range (overbought territory).It then goes back below 70. Again makes a high but does not reach above 30 this time. Eventually makes a low that is lower than its previous low.

The chart below shows case for a bullish swing rejection. 

• Double Crossover Signals: Suppose we have two RSIs (20 and 100) plotted below chart. 
  
  Traders consider it a bullish signal if there is a bullish candle on the price chart when the Short Average crosses above the Long Average. Wait for the next candle. If this candle closes higher than the previous crossover candle, it indicates a buy signal. 
  Traders consider it a bearish signal if there is a bearish candle on the price chart when the Short Average crosses below the Long Average. Wait for the next candle. If this candle closes lower than the previous crossover candle, it indicates a sell signal. 

Are all RSI Signals Reliable?

Not all signals are accurate and trades must carry out every trade with great discretion. Relying solely on a single indicator is not advisable. The crossover strategy or other strategies may give false signals. Traders must be prepared for that. We can never predict the market accurately all the time. 

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