The RSI indicator has been around and has remained popular since the late 1970s. It is no wonder that RSI trading strategies have developed and have been relied upon by intraday traders in diverse financial markets all across the world.
The RSI, or relative strength index, is a technical indicator that was unveiled by J. Welles Wilder Jr. in his 1978 published book, “New Concepts in Technical Trading Systems”.
Wilder developed the relative strength index as a momentum indicator, or oscillator, that calculates the speed and magnitude of price change. This information measures price movements to evaluate overbought and oversold levels of a financial asset.
Though it may give out infrequent trading signals depending on the asset, the information it contains proves to be extremely valuable to most traders.
The goal of this article is to provide some insight as to how to use the RSI for day trading and apply its information to your trading style.
RSI Indicator Overview
Let’s do a quick overview of the RSI indicator in case you need to be refreshed on what kind of information it displays or the way it works. Note, that to implement any kind of RSI trading strategy, you must understand the relative strength index indicator.
If the RSI indicator is new to you, I suggest reading the following article:
Facts About the RSI Indicator:
- The relative strength index is a leading indicator. A leading indicator is a statistical measurement that can forecast market change and help traders predict price behavior.
- RSI settings utilize 14 periods of data. There is a mathematical RSI formula, but luckily, trading platforms do the work for you and contain a default RSI setting. Experienced traders may customize the RSI indicator settings to suit their personal trading strategies.
- The RSI indicator is a line graph that moves between two extreme values of zero to one hundred, which displays an asset’s overbought or oversold condition.
- The RSI indicator can display divergence between the RSI line and the actual direction of price movement on the price chart.
- The RSI indicator best performs in ranging markets. It is important to know what the RSI looks like in trending markets to avoid false signals.
- The RSI indicator is most reliable when its information is validated by other technical indicators, moving averages, and trading strategies.
RSI Trading Strategy: Overbought and Oversold Levels
The RSI indicator is a line graph that moves between two extreme values of zero to one hundred.
An RSI value of 70 or above signals an overvalued market condition. A value of 30 or below signals undervalued levels for a financial security.
A market can be overbought or oversold when the price movements are too far away from an average value in either direction. When this occurs, the price will eventually snap back or come close to the actual average or intrinsic value.
When these market conditions exist, day traders may suspect that the market will revert to an average means and a trend reversal or market pullback will take place.
An RSI trading strategy supporting the overbought and oversold theory would be:
1) to buy a long position or an option call when the RSI value is low and sell that position as the RSI value increases for profit.
2) The opposite would be to short the market or buy an option put when the RSI value is higher and sell the position when the RSI value decreases.
An RSI buy signal or sell signal in an oversold or overbought zone is more significant when validated by other trading strategies such as support and resistance, moving average crossovers, and/or other technical indicators.
RSI Trading Strategy: RSI Divergence
The RSI indicator can display bullish divergence or bearish divergence. Divergence occurs when two pieces of data directionally conflict.
For example, when the RSI indicator is moving in the opposite direction of price, divergence is present. These kinds of conflicts in data can hint that future trend reversals or market corrections may occur.
Bullish Divergences: When the price formed lower lows, but the RSI formed higher lows, bullish divergence conditions existed. The strength of the asset’s bearish trend or downtrend in price is losing power and a move to the upside may soon take place.
Bearish Divergences: When the price forms higher highs but the RSI creates lower highs, we have bearish divergence. The conflicting data tells a trader that buyers may be losing steam. The existing bullish trend will possibly soon end, and bearish price momentum will take over.
A way to trade RSI divergence:
Identify if the divergence is a bearish or bullish divergence. Look for the break of either the overbought zone or the oversold zone. Find confluence by using other means of technical analysis and trading strategy to confirm the market atmosphere.
RSI Trading Strategy: Trending Market Conditions
The RSI indicator best performs in ranging markets rather than a market that is trending. It is important to know what the RSI looks like in trending markets to avoid false signals.
If the RSI line is in overbought territory (a value of 70 or above, or near that range) for an extended period, the asset’s price is in a bullish trend.
When the value of the RSI indicator is 30 or below, this is considered an oversold reading. If the RSI line remains in or near this range for a while, the market is in a bearish trend.
RSI signals may be difficult to obtain during trending days. When the price is trending, it is important to not rely on the RSI to produce an accurate buy signal or sell signal based only on an overbought or oversold reading.
A way to trade an RSI trending market:
A trader should await evidence of RSI divergences or rely on RSI support or resistance to be retested before confirming bullish and bearish movements. Utilizing support and resistance in the RSI indicator will allow a trader to spot continuations and possible reversals in price. Looking out for divergence will provide a hint that the market direction may be shifting.
Summary: Using RSI for Day Trading
Using the RSI indicator to trade an asset can prove to be a successful method, though some traders get frustrated with the infrequent buy signals and sell signals it generates.
It is important to know the RSI settings and the information the RSI indicator conveys before implementing a trading system around it. The RSI period setting can be changed so that the indicator is more sensitive to shorter-term market conditions, producing more frequent signals.
Regardless of any adjustment, an overbought signal or oversold signals should be confirmed by the use of other indicators. An example would be the MACD or moving average convergence divergence. Other means of confluence would be a moving average or exponential moving averages, technical analysis such as candlestick patterns, and various methods of strategy such as using supply and demand zones.
Trading the market carries significant risk. Practice using the relative strength index on the financial instrument you desire to trade before trading it live. Trade only with capital you are willing to risk. Once you gain confidence in your trading system, stick to your rules and never let emotion get the best of you!
A wise man once said, “Letting your emotions override your plan or system is the biggest cause of failure.” – J. Welles Wilder Jr.
Maurice Kenny has helped over 600 people become financially free through one-on-one coaching, mentorship, and options trading strategy. Many of these new traders are now full-time traders, and they all started by watching his 1-hr webinar.
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