There are a dizzying number of technical indicators you can implement in your day trading endeavors, but few are as tried-and-tested as the Relative Strength Index. In this article we’ll go over what precisely the RSI Indicator is, and how you can use it to identify profitable market entry points when the opportunity arises.
What Is The RSI Indicator?
The Relative Strength Index (RSI) is a tool used in technical analysis to measure the rate of change in price movement of an underlying asset. The indicator was initially conceived by J. Welles Wilder Jr. in 1978, and has gone on to become a popular momentum oscillator used by many traders today.
As with other momentum indicators, the RSI is used to gauge the relative strength or weakness of a security. Traditionally, the oscillator is calibrated to a scale of 0 to 100, where any value over 70 suggests the asset under consideration is overbought or overvalued, and any value under 30 indicates that it is oversold or undervalued.
The RSI is formulated so that the calculation closely approaches 100 or 0 when the market is strongly trending in an either upward or downward direction respectively.
What Does The RSI Indicate?
Because the RSI can be used to measure the price momentum of any security, it can also help traders identify when a trend reversal is likely to happen.
By using a selection of moving averages and comparing them to the current RSI chart, it is possible to make a decision on whether a trend will continue in its present direction, or if a reversal is on the cards. This phenomenon is known as divergence, and we’ll explore this topic in further detail in the next section.
What Does Divergence Mean In Trading?
In the world of technical analysis, divergence is what happens when the price of a security moves in a direction opposite to that implied by some other indicator or data set, which in our case would be the Relative Strength Index.
Divergence can be either positive or negative: positive if the divergence suggests the price of an asset could move higher, or negative if it suggests it will move lower.
In practice, what this means is that a positive divergence signal occurs when a technical indicator trends upwards, but the price of the security it is tracking moves lower. In the same way, a negative divergence signal happens when the indicator trends downwards, but the price is going up.
Why Does RSI Divergence Happen?
The implication of a divergence signal is that a major price move may be about to happen.
One example of this would be when a stock continues to make new lows at the same time that the RSI Indicator makes higher lows with every periodic swing in the asset’s price.
A trader could conclude from this that the stock is losing downward momentum, and that the current trend will change direction too.
This would be a positive, bullish divergence, and would signal to a trader to think about opening a long position in the security.
How Do You Check RSI Divergence?
It’s important to understand the general trend in a security before using the RSI Indicator to check for divergence signals. For instance, when a stock is in an uptrend, it’s very likely that the security could still be oversold, even when the RSI reading is above 30.
Likewise, in a downtrend, the asset could be overbought even when the RSI is showing a level under 70.
Furthermore, traders can avoid false alarms from their RSI readings by focusing on bullish signals when the market is on the rise, as well as bearish signals when it is falling. This is known as confirmation, and traders can use a multitude of indicators to signal when the time is best to open or close a particular position.
How To Use RSI Divergence
Once you’ve identified an RSI divergence pattern on any of your various trading charts, it’s time to enter the market, with the next step being to spot when a price reversal begins to take place.
It’s critical to remember here, however, that just because divergence has happened, it doesn’t mean that it’s time to trade right away. The actual price reversal doesn’t always occur immediately, and may in fact take days, even weeks, to manifest.
With that said, if there is a clear price action signal, it’s time to place a stop loss order on the correct side of the reversal point – depending on whether you’re trading a bullish or bearish divergence – and then hold the trade until the price conditions are right for you to take your required profits.
It would also make sense to supplement and strengthen your trading strategy by using other technical indicators, such as the stochastic oscillator or the moving average convergence divergence (MACD).
How Accurate Is RSI Divergence?
As with most technical indicators, the divergence you identify between the price action of an asset and the RSI Indicator is generally more reliable when it conforms to the pre-existing long-term trend, and also when it’s calculated over a longer time frame.
For traders this usually means having to take fewer positions in the market – but larger profits if all goes right.
It’s also true that because the RSI Indicator is essentially a measure of price momentum, it can show values that suggest the security is overbought or oversold for long, drawn-out periods of time. While this can be be frustrating and appear like a limiting defect, it also means that divergence is a particularly strong signal when the market is oscillating between bullish and bearish conditions.
Finally, divergence is neither a necessary nor sufficient indicator that a price reversal is about to take place, and market momentum can change without an accompanying divergence signal too.
Which Time Frame Is Best For RSI Divergence?
Divergence is best measured over long time intervals, so it stands to reason that the wider the time frame for calculating divergence, the better the results.
When using the Relative Strength Index in technical analysis, the standard time frame is 14 periods, or 14 days, although there are no hard or fast rules about this, and traders can use whichever interval length they feel most comfortable with.
Some traders, depending on the type of asset class they are trading, might prefer to increase or decrease this time frame. For instance, crypto-currency traders might feel that a shorter trading period is more appropriate, given that security’s tendency for quick, rapid-fire price movements, whereas traders in less volatile markets, whose underlying asset is less prone to large price swings, might use a 50-day period instead.
It should be noted here as well that traders are not just limited to using the 30 and 70 levels when implementing the RSI indicator either.
For some, it’s more prudent to use an alternative 20 and 80 setting, since this will necessarily increase the accuracy of any signal, while making the frequency of those signals less regular too. However, this also means that some genuine momentum shifts will be missed, preventing the opportunity to enter into a potentially profitable trade.
RSI Divergence Indicator: Conclusion
The RSI Indicator is a reliable way to identify whether an asset is displaying overbought or oversold momentum, and, when used in conjunction with other metrics – such as a security’s actual trading price – it can be an especially powerful tool to predict trend reversals over the long-term when divergence conditions appear.
While the RSI Divergence Indicator isn’t perfect, and should rarely be used alone or without additional confirmation from other momentum oscillators, the Indicator can be customized to reflect different measuring tolerances, and remains still one of the most important tools in any trader’s kit-bag.
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