The RSI Indicator: A Simple Explanation

In the complex and volatile world of financial markets, investors and traders are constantly seeking effective tools and strategies to achieve success and obtain profits. One of these fundamental tools in the trading realm is the RSI technical indicator, widely used by both experienced traders and newbies to analyze price fluctuations and make informed investment decisions.

In this article, we will delve into this well-known technical indicator, from its basic concepts to the most popular RSI trading strategies. Additionally, we will provide practical tips and concrete examples that will help you understand how to apply it effectively and make the most of its various settings.

The Essence of the Relative Strength Index (RSI)

The Relative Strength Index, known as RSI for its English initials, is one of the most renowned technical indicators in the trading universe. It was developed by engineer and technical analyst J. Welles Wilder in 1978. This indicator evaluates the speed and magnitude of price changes in a financial asset (such as a currency, a stock, or a commodity), providing insights into the strength of the current trend and possible reversal points.

The RSI formula calculates the relationship between gains and losses over a specific period, usually 14 days, and presents the result on a scale of 0 to 100.

The fundamental principle behind the use of the RSI is based on Wilder's theory that prices move in short-term and long-term cycles. Identifying moments when the market price has risen or fallen excessively helps to detect possible reversal levels and, therefore, to capitalize on trading opportunities.

Interpretation of RSI Signals

The RSI provides four main types of signals:

1. Overbought and Oversold

The most basic reading that traders get from the RSI technical indicator is the overbought and oversold levels in the market price.

These terms are used in technical analysis to describe situations where an asset is considered to be trading above (overbought) or below (oversold) its real value.

In the context of the RSI:

• Overbought: Indicates a market condition where prices are believed to have increased excessively and may be close to a correction or decline. In the RSI, this condition is generally identified when the indicator exceeds the level 70.

• Oversold: Indicates a market condition where prices are estimated to have decreased excessively and may be close to a recovery or rise. In the RSI, this condition is usually determined when the technical indicator falls below the level 30.

2. Divergence

The term "divergence" in momentum indicators, such as RSI, Stochastic, and MACD, refers to the discrepancy between the direction of the price and the direction of the momentum indicator line.

When the price moves in a specific direction (upward or downward), while the momentum indicator moves in the opposite direction, this suggests a possible reversal signal. This reversal can be bullish or bearish:

• Bullish Divergence:

It occurs when the price declines ( bearish trend ) while the momentum indicator rises. This suggests that the bearish trend may be losing strength and there is the possibility of an imminent reversal to the upside.

• Bearish Divergence:

It occurs when the price rises (bullish trend) while the momentum indicator declines. This indicates that the bullish trend may be losing momentum and there is a possibility of a forthcoming downward reversal.

Divergence in momentum indicators can be a powerful signal for traders to anticipate reversals or changes in the direction of prices.

3. Determining the Direction by Crossing the Central Line

The RSI can also be used to assess the strength of the current trend. When the RSI line crosses above the 50 midline, it is a signal that the price may be starting an upward movement. Conversely, when the RSI line falls below the 50 midline, it suggests that the price may be starting a downward movement.

It is crucial to remember that while the RSI can provide valuable signals, it should always be used in conjunction with other analytical tools to confirm the validity of these signals and minimize the risk of false indications.

Advanced Configuration of the RSI Technical Indicator

When examining the RSI technical indicator, we observe that it comes with widely used default settings. Naturally, these settings can be adjusted to fit your personal trading style or to improve the accuracy of the indicator's signals.

These are the main settings:

1. Time Period: The adjustment of the period generally expresses the number of time intervals analyzed. The default setting for the period in the RSI is 14, but it can be modified according to your needs. If you prefer short-term analysis, you can reduce the period to 7, while you can increase it to 21 or more if you opt for long-term analysis.

2. Overbought and Oversold Levels: The default values for the overbought and oversold levels of the RSI are 70 and 30, respectively. You can adjust them according to your strategy and the assets you are trading. For example, if you are trading assets with stable prices and low volatility, it is recommended to lower the upper level to 40 or 60 to get more signals.

3. Combination with Other Technical Indicators: You can also combine other indicators with the RSI to improve performance. For example, using a Simple Moving Average (SMA) or a Stochastic indicator along with the RSI can provide more accurate trading signals.

The use of these custom settings allows you to optimize the performance of the RSI technical indicator and turn it into a more effective tool for making more informed trading decisions.

Beyond the Levels 30/70

Although the 30 and 70 levels of the RSI are commonly used to identify oversold and overbought conditions, they may not be optimal in all market scenarios. The interpretation of RSI signals is significantly influenced by different markets and changing economic conditions, which requires a more flexible and thoughtful approach in the use of this technical indicator.

As mentioned earlier, in low volatility markets, using less extreme levels such as 40 and 60 in the RSI can provide a different approach, focusing on identifying market conditions that, while not overbought or oversold, may indicate the beginning of a change in momentum or confirmation of the current market trend.

Using the 40 and 60 levels can also help confirm the continuation of a trend. For example, in a bull market, an RSI that stays above 40 and crosses 60 can be considered an indication that the bullish trend continues strongly. Similarly, in a bear market, an RSI that remains below the 60 level and crosses downwards through the 40 level can be interpreted as a signal that the bearish trend persists vigorously.

80% Confidence Level

Some traders choose to use more extreme levels, like 20 and 80. These levels are more conservative and can reduce the number of false signals in a highly volatile market, increasing the likelihood of capturing market changes more reliably.

Adjusting the overbought and oversold levels of the RSI to 20 and 80, instead of the standard values of 30 and 70, can offer advantages in certain cases and be used for specific trading purposes. Here are some of the benefits and use cases of these modified levels:

Reduction of False Signals:

In markets with high volatility, raising the overbought and oversold thresholds by adjusting the RSI levels to 20 and 80 can reduce the number of false signals. By setting stricter criteria to identify extreme conditions, the indicator becomes more conservative and decreases the likelihood of reacting to normal price movements or market noise.

Focus on Significant Movements:

The use of levels 20 and 80 helps to focus on large and important price movements, which means that traders can act based on stronger and clearer signals regarding overbought or oversold peaks.

Long-Term Trading Strategies:

Levels 20 and 80 can provide traders with long-term strategies focused on significant trend changes, safer entry points, and limiting the risk of premature or late entries.

Identification of Solid Buying or Selling Opportunities:

When the RSI falls below 20 or rises above 80, this can indicate strong buying or selling opportunities, respectively, as the markets have reached extreme levels of oversold or overbought.

RSI Strategies Used by Experts: Essential Mastery

The Best RSI Strategies

The Relative Strength Index (RSI) is a versatile tool that can be applied in various strategies to identify strong trading opportunities in financial markets. There are numerous trading strategies that utilize the RSI technical indicator, either independently or in combination with other indicators and technical tools.

Below, we present some of the most prominent strategies employed by professional traders and market experts:

1. Divergence Strategy:

   • This strategy is based on identifying the occurrence of divergences between market prices and the RSI technical indicator.

   • When a bullish divergence forms, where the RSI increases while market prices decrease, this may indicate a potential trend reversal to the upside, being considered a possible buy signal.

   • On the contrary, when a bearish divergence forms, in which the RSI decreases while market prices increase, this may indicate a possible trend reversal to the downside, which could be interpreted as a sell signal.

2. Breakout Strategy:

   • This strategy is based on breaking through overbought or oversold levels such as 70 and 30(.

   • When the RSI crosses the 70 level from above, it could be considered a sell signal.

   • When the RSI crosses above the 30 level from below, it could be interpreted as a buy signal.

3. Overbought/Oversold Reversal Strategy:

   • This strategy uses overbought and oversold levels ) like 70 and 30( to identify trading opportunities when the RSI surpasses them.

   • When the RSI crosses above 70 and subsequently falls back below this level, it could be considered a sell signal.

   • When the RSI crosses below the level of 30 and then rises back above it, it could be interpreted as a buy signal.

4. Support and Resistance Strategy:

   • This strategy combines market support and resistance levels with the RSI technical indicator.

   • When the RSI exceeds 70 and the price approaches a resistance level, it could be considered a sell signal.

   • When the RSI crosses above 30 and the price approaches a support level, it could be interpreted as a buy signal.

These strategies can be complemented with other technical analysis tools, such as candlestick patterns and support and resistance levels, to improve the accuracy of the analysis. Professionals often combine multiple technical indicators to validate signals and conduct a more thorough analysis.

In future articles, we will delve into the most relevant strategies applied to the RSI technical indicator, providing a detailed guide for its effective implementation in trading.