- A momentum indicator that shows whether the security is overbought or oversold.
- The RSI ranges from 0 to 100, a value above 70 indicates overvalued and a value below 30 signals undervalued.
A quick introduction
The Relative Strength Index (RSI) is one of the most commonly used technical indicators to trade securities. First introduced back in 1978 by J. Welles Wilder Jr., the momentum indicator is intended to provide signals about market conditions, such as bullish or bearish price momentum within a time period (14 period is the most common). The calculation of the RSI is somewhat complex, but you can easily plot it on your chart using charting tools like TradingView.
What does it tell us?
The RSI works best when a trend is forming because it’s plotted as a line (oscillator) that relates the number and size of positive closes to the number and size of negative closes. So, if the market is bullish, the RSI will increase because the recent closing prices are higher and greater than the short-term dips or negative closes.
In other words, if bullish pressure is strong, the RSI will cross above the 70-threshold as more participants push the price higher. The key takeaway is that the momentum indicator rises as the size and number of positive closes increase, and decreases as the size and number of negative closes increase.
Think of it this way, if bulls continue to push bitcoin up, investors will eventually begin to reap some profits and bullish momentum becomes fragile since the king is overvalued or overbought (RSI > 70).
How to use it
There are different ways that you can incorporate the RSI in your trading strategy. For starters, you can always buy once the indicator crosses above 70 and holds as it signals a bullish trend. However, you’ll want to be cautious once the RSI crosses below 70 because the size and number of negative closes are increasing concerning positive closes.
Divergence
A divergence occurs when the indicator signals a shift in trend before it’s reflected in the price action. For example, let’s say that bitcoin continues to push forward, but as the RSI remains above 70 for a long period (overextended market condition) it will become overbought, and the indicator will begin to form lower highs as the price of bitcoin makes the last attempts to hit higher highs. The indicator is telling us that the engine is overheated (overvalued) and a retrace is expected for the engine to cool-off. Bear in mind that during long-term trends it’s rare to see divergences, so if you see a major divergence, get ready for a shift in trends.
Conclusion
RSI is one of the most popular momentum indicators because it’s easy to use and interpret. Being bounded by two extremes and having the bullish zone and bearish zone defined, you can identify when bulls are in command or if bears have stepped up. As always, it’s best to include other indicators in your analysis to avoid false breakouts. Try using other momentum indicators and defining key price levels for more accuracy.
If you want to learn more about the Relative Strength Index, be sure to check out this video:
