RSI in detail and how to effectively use itWhat is RSI?
RSI stands for Relative Strength Index; The RSI measures the strength of asset's price action by comparing the magnitude of its recent gains to the magnitude of its recent losses.
The RSI is calculated using the average gain and average loss over a specified period, typically 14. The formula for the RSI is:
RSI = 100 - (100 / (1 + RS))
where RS = Average Gain / Average Loss.
To calculate the average gain, add up the gains over the specified period and divide by the number of periods.
Average Gain = Sum of Gains over N periods / N
To calculate the average loss, add up the losses over the specified period and divide by the number of periods.
Average Loss = Sum of Losses over N periods / N
In simple terms : To determine the average gain/loss for the closing price of the asset for each period in the selected time.
Calculate the difference between the closing price of the current period and the closing price of the previous period. If the current closing price is higher than the previous closing price, the difference is considered a gain. If the current closing price is lower than the previous closing price, the difference is considered a loss. Then calculate the average loss by summing up all the losses over the specified time period and dividing them by the number of periods in the timeframe.
What does RSI tell you?
To understand RSI we must understand the term Relative Strength which refers to the ratio of the average gain to the average loss over a specified period. It is used to compare the strength of the stock or asset price gains to its price losses over a certain timeperiod.
For example, let's say we want to calculate the relative strength of a stock over the past 14 trading days. We first need to calculate the average gain and average loss over that period. Suppose the average gain is USD 2 per share, and the average loss is USD 1 per share.
To calculate the Relative Strength (RS), we divide the average gain by the average loss:
RS = Average Gain / Average Loss
= USD2 /USD 1
= 2
RS value greater than 1 indicates that the stock has experienced more gains than losses over the specified time period. In this case, the RS value of 2 indicates that the stock has had twice as many gains as losses over the past 14 trading days. The higher value of relative strength indicates Buyers have been relatively stronger than sellers over a period of the time and vice-versa of the relative strength is below 1, which indicates sellers have been stronger compared to buyers over a period of time.
When the RS remains above 1 over an extended period of time the RSI plot will keep rising, it can have a maximum value of 100. Any value higher than 70 for RSI is considered overbought and an RSI value below 30 is considered oversold.
What is overbought and oversold?
Overbought is a zone in time and the price of an asset that has risen in price rapidly and is now considered to be trading at a higher value than its true worth or fair value.
When an asset becomes overbought, it means that there are more buyers in the market than sellers, causing the price to increase rapidly. This can occur when investors become overly optimistic about the asset's future prospects or when there is a surge in demand for the asset.
However, an overbought asset is not necessarily a signal to sell. In fact, some traders and investors may view an overbought asset as an opportunity to profit from further price gains. Nevertheless, an overbought asset is often seen as a warning sign that the price may be due for a correction or pullback, as it may have become detached from its underlying fundamentals or economic conditions.
Oversold conditions are simply the opposite of overbought.
Why is RSI above 70 considered overbought?
The reason a reading above 70 is considered overbought in RSI is because it is a widely used and accepted threshold. The value of 70 is not based on any specific mathematical or statistical calculation, but rather it is a commonly used level that has been found to be effective over time. Now because it's a commonly used threshold it becomes self-fulfilling prophecy, where everyone starts acting on it and start selling the asset or at least being to anticipate coming pull back, which leads to slowdown in buying and increased selling, which causes RSI to start going down in oversold territory and the cycle is repeats.
How to effectively use RSI?
For a long trade:
Step 1: Use it on mid to high term timeframe ideally 4h and above.
Step 2: Wait for the RSI to come to the oversold zone.
Step 3: To make sure RSI oversold conditions are to be trusted for entering a trade, the Price must be a key support level and holding it.
Step 4: If all above conditions are met, then fearlessly enter a trade.
For a Short trade:
Step 1: Use it on mid to high term timeframe ideally 4h and above.
Step 2: Wait for the RSI to come to the overbought zone.
Step 3: To make sure RSI overbought conditions are to be trusted for entering a trade, the Price must be a key resistance level and rejecting it.
Step 4: If all above conditions are met, then fearlessly enter a trade.
What happens if Price fails to hold Support or Breaches Resistance in step 3 above?
That's where divergences come into play.
What is a divergence?
Divergence is a technical analysis concept that occurs when the price of an asset and its RSI indicator move in opposite directions, indicating a potential trend reversal.
There are two types of RSI divergences: bullish divergence and bearish divergence.
Bullish divergence occurs when the price of an asset makes a new low while the RSI indicator makes a higher low. Remember from explanation provided in sections above, this suggests that even though the price is going lower there
are more buying activities than selling and the assets are becoming stronger, and a potential trend reversal may be imminent.
Bearish divergence, on the other hand, occurs when the price of an asset makes a new high while the RSI indicator makes a lower high.
I have highlighted bullish divergence in chart with purple line.
Bullish and Bearish Divergences are even more powerful signals for taking trades, but we must make sure price is holding a support or rejecting from a resistance before taking the trades, otherwise divergences can easily disappear.
Why do traders fail to effectively use RSI?
The primary reason is lack of experience in trading.
Which leads to impatient behavior.
No risk management skills. (Taking too much risk)
Lack of trust in self when taking trades, (Keep stopping losses too tight which knocks them out of the trades).
I have show several instances where RSI generated long signals and all of them were successful , the only reason a trader would not be able to use RSI effectively is because of above reasons.
