Relative Strength Index (RSI)

This is one of the most important indicators to learn. Believe me, I don't say it every time. So please pay extra attention to this lesson. Ok?

So, the Relative Strength Index, or RSI, is a popular tool used by traders to measure the speed and change of price movements. Developed by J. Welles Wilder in 1978, RSI helps traders identify whether an asset is overbought or oversold, which can signal potential price reversals.

RSI is widely used because it’s simple to understand and effective in different market conditions. By showing the balance between recent gains and losses, RSI helps traders gauge the strength of a trend and spot possible turning points in the market.

How RSI Works

RSI calculates the ratio of recent upward price changes to recent downward price changes over a specific period, usually 14 days. The result is a number between 0 and 100:

• Above 70: the asset might be overbought, suggesting a possible price drop.

• Below 30: the asset might be oversold, indicating a potential price rise.

Calculating RSI

Here’s a simple way to understand how RSI is calculated:

1. Determine Price Changes:

   For each day, see if the closing price is higher or lower than the previous day.

2. Average Gains and Losses:

   Calculate the average of all gains and the average of all losses over the chosen period (typically 14 days).

3. Compute Relative Strength (RS):

   Divide the average gain by the average loss.

4. Calculate RSI:

   • Use the formula:

     makefileCopy codeRSI = 100 - (100 / (1 + RS))

   • This scales the RSI between 0 and 100.

Most trading platforms do these calculations for you, so you can focus on interpreting the results.

Reading the RSI Indicator

RSI is displayed as a line that moves between 0 and 100. Here’s how to interpret it:

• Overbought (Above 70). When RSI is above 70, the asset may be overbought. This could mean it's time to sell or prepare for a price decline.

• Oversold (Below 30). When RSI is below 30, the asset might be oversold. This could be a good time to buy or expect a price increase.

• Middle Line (50),. RSI above 50 suggests an upward trend, while below 50 indicates a downward trend.

Using RSI in Trading

RSI can help you make informed trading decisions in several ways:

• Spotting Overbought and Oversold Conditions:

  • If RSI moves above 70, consider selling or shorting the asset.

  • If RSI drops below 30, consider buying or going long on the asset.

• Identifying Divergences:

  • Bullish Divergence: When the price makes a new low but RSI doesn’t, it may signal an upcoming rise.

  • Bearish Divergence: When the price makes a new high but RSI doesn’t, it could indicate a potential drop.

• Confirming Trends: Use RSI alongside trend indicators like Moving Averages to confirm the strength of a trend.

Exercise

Let’s look at how RSI works with a real example. Open a trading simulator or demo account and scroll historical data until you find the right time frame. It must fit in the scenario described below.

Scenario: Trading a Stock on a Daily Chart

1. Identifying Overbought Conditions:

   You notice the RSI of NVDA stock has risen to 75. This suggests the stock might be overbought. If you don't trade stocks, and trade, for example, crypto, you can choose another asset (for example, BTC).

2. Watching for a Reversal:

   A few days later, the RSI starts to drop below 70 while the stock price remains high. This could indicate that the upward momentum is weakening.

3. Making a Decision:

   Seeing the RSI decline, you decide to sell your position to protect your profits before the price potentially drops.

Use RSI in this conditions and make some demo trades. Write down your results. If your trades failed, repeat this exercise untill you get a good result. It worth time spent. As I said before, this is one of the most important indicators. If this lesson was not clear enough, I recommend you watching some videos. For example, this one:

With time and experience, RSI can help you navigate the markets more confidently.