Who has never dreamed of getting into trading? One of the easiest ways to get started in the world of trading is through technical analysis.
One of the first things you learn in technical analysis, besides support and resistance levels, are the indicators. Today we will focus on one of the most popular and easy-to-use indicators, the RSI.
What is the RSI?
Relative Strength Index (RSI) was created by Welles Wilder in 1978 and is one of the most widely used indicators in technical analysis, appearing in the first chapter of many books on the subject. It is used to evaluate the strength of a current movement.
It belongs to the category of oscillators and is bounded between 0 and 100. Visually, it takes the form of a line oscillating between 0 and 100. It is said to be bounded because, unlike the MACD for example, it cannot exceed either 0 or 100.
The indicator also has an overbought zone between 70 and 100, the closer the value is to 100 the more an asset will be overbought. The oversold zone ranges from 0 to 30.
How to interpret it?
This will depend on several factors such as time horizon and trading style. For simplicity, we will discuss here the main way to analyze this indicator, namely the oversold and overbought areas.
As mentioned above, when the RSI hovers above the 70 level, we will say that the asset is overbought and we can expect a retracement. Conversely, when the RSI moves below the 30 level, the asset is oversold and a rebound can be expected.
Specifically, when the RSI is below the 30 level, we will wait for the RSI to go back above that level to open a long position. Conversely, when the RSI is above 70, we will wait for it to return below that level to open a short position.
We can see an example of this use on the graph above. Of course, the use of this indicator alone will never be sufficient to constitute a trading strategy.
Advanced trading strategy
We’ve covered one of the easiest ways to use the RSI, now let’s dive into the other side of the oscillators, the divergences. There are two types of divergences, classic divergences, and hidden divergences. Both types can of course be bullish or bearish.
A classic bullish divergence occurs when prices mark a new low while the RSI marks a higher low. It increases the probability of a rebound if this divergence is coupled with a breakout from the top of the 30 level. An example of this can be seen in the chart below. The reverse is also applicable for a bearish case.
Hidden divergences are a little more difficult to spot but they are not very complicated either. For a hidden bullish divergence, prices mark a higher low while the RSI marks a lower low. We can see an example of this just below.
An indicator alone, as explained above, is never the solution for creating a trading strategy. It is true that simplicity is sometimes very good in a trading strategy but limiting yourself to one indicator is really too reductive.
At the very least you need to add a volume analysis and a filter to your strategy. As always though, your emotional control will prove to be the most crucial point.