A simple introduction to the Relative Strength Index (RSI)

The RSI is a momentum indicator that oscillates between 0 and 100, measuring the magnitude of recent price changes.

Let’s start our series on technical indicators with Relative Strength Index or short the RSI. The RSI is probably one of the most well known indicators around. By searching for it on Google you will various articles about it, how it works and how you can apply it in trading. Within this post i will only touch on the basics, you will find those in detail, as I already mentioned all over the internet, but I want to go into detail on lesser known aspects, like ranges, levels and (exponential) moving averages.

The Basics

First things first, let’s dive a little bit into the RSI. The RSI is a so called momentum indicator. If you ask yourself, what is momentum actually, I will go into it in another post soon. If you need to know now, have a look here: Market Momentum (Investopedia). Another aspect of the RSI is that it is an oscillating indicator, which means that it ranges between a certain maximum and minimum which is set. In case of the RSI between 0 and 100. In short, the RSI takes the average gains in relation to the average losses over a certain amount of periods in the past (default periods is often 14). If you are interested in the formula to determine the RSI yourself check it out here: Relative Strength Index (Investopedia).

As you can read on most of the article regarding the RSI it has two key levels, 70 and 30. A RSI above 70 means overbought and below 30 the market is oversold. Another wide spread approach on trading with the RSI are divergences. A divergence is the situation when the RSI does not develop in parallel with the price action, for example the RSI marks a lower high, although the price of the assets sets a higher high (see picture below). This is called a bear divergence. In trading we usually differ between four variants of divergences:

1. (Regular) Bull Divergence - Lower Low on Price and Higher Low on RSI

2. (Regular) Bear Divergence - Higher High on Price and Lower High on RSI

3. Hidden Bull Divergence - Higher Low on Price and Lower Low on RSI

4. Hidden Bear Divergence - Lower High on Price and Higher High on RSI

In many articles you will find the approach on solely relying on those divergences whith you trading. Something I would strongly oppose, never rely on divergences alone. They can be good signals for the market being ripe for turning around or continuing their trend, but for a decent setup you need more confluence than divergence alone.

A little different approach on the RSI

I for myself learned a different approach on the RSI and it is mainly based on certain ranges and levels, hidden divergences and the application on moving averages, but one thing at a time.

The key levels and ranges of the RSI

There are traders out there, a shout goes out to Andrew Cardwell, who propagates the application of certain ranges based on the RSI to determine whether a market is in a bull or in a bear trend. The following approach is mainly influenced by him. I adapted it my own best practice.

A bullish trend is an RSI between the levels of 80 - 40.

A bearish trend is determined by a RSI between 60 -20.

You might ask yourself, but what is if the RSI is in between 40 and 60. It is necessary to identify where the RSI is coming from, once it crosses above 60 we can consider prices out of the bear trend if it then stays above 40 and holds this level we can consider the market being in a bull market. Vice versa, once the RSI drops below 40 and gets rejected on the 60 level afterwards we can consider the market being in a bear market.

General characteristics of an uptrend regarding this method:

• RSI in a range between 80 and 40

• Top Bottom Support - tops (highs) on the price often act as a support for further expansion

• Bearish Divergence - those are often signs of an uptrend and on their own do not indicate a reversal (see picture below on reversals)

• Positive Reversals (see below)

• Higher Highs and Higher Lows - basic market structure

In contrast characteristics of a downtrend:

• RSI range between 60 and 20

• Bottom Top Resistance - Price bottom (lows) often act as resitance for further declines

• Bullish Divergence

• Negative Resersals (see below)

• Lower High and Lower Lows

Positive & Negative Reversals (Hidden Divergences)

As listed above positive and negative reversals are key characteristics of an up- or downtrend. So first of all positive reversals only count within an uptrend and should happen around and above 40. Same goes for the negative reversals in downtrend below and around 60 on the RSI.

Positive Reversals (PR) are when the RSI values marks a lower low while the price of the assets marks a higher low.

Negative Reversals (NR) appear when the RSI value reaches a higher high while the price only reached a lower high.

In generals those are hidden divergences as we learned above. The aspect that these appear while being in an according up- or trend makes them a PR or NR according to this approach.

With the general trend of the market PR and NR you already have two very clear aspects of a potential setup. This leads me to the last piece of this approach, moving averages coming in the next section.

Application of Moving Averages

Next step is the use of moving averages, to be more specific a simple moving average (SMA) with the length of 9. A fast paced average that reacts quickly to changes in price action. Additionally, a slower pace exponential moving average (EMA) with the length of 45. We apply them to the price and also to the RSI (see below).

Moving averages have the advantage to smooth the course of price action and also oscillators like the RSI. By the application of a fast (SMA(9)) and a slow moving average (EMA(45)) they can tell us the short term and a rather longer term trend of the momentum (RSI) and the price. In our application the moving averages can act in three different ways:

1. (E)MA Cross: Cross over of the moving averages, either on price or RSI. A very common application of moving averages are cross overs, once one MA crosses above or below another many traders consider to trade, e.g. fast MA crosses above slow MA = Long / fast MA crosses below slow MA = Short. Cross overs can also be applied on oscillators like the RSI. An interesting setup is when SMA(9) and EMA(45) cross on price and RSI at the same time, take some minutes and check that for yourself.

2. Dynamic support and resistance: Moving averages can also act as support and resistance. If you have a look below on the example you can see that EMA(45) as a support for the price of Bitcoin during the majority of the most recent bull market. Once it broke below, shortly after the uptrend was over. Anoither example, if the price of Bitcoin managed to climb above the SMA(9) we usually experience a steep increase in price and once it broke below we saw a shor term correction down to EMA(45) before price soared again to new highs.

3. Price to moving averages: In combination with the general trend (directional bias - we touch this in another article) and positive or negative reversals the relation of price or RSI to the SMA(9) is the most important trigger for my setups. As you can see in the example below, once price or RSI - even better both - climb above the SMA(9) we have a potential trading setup. You can also observe if the price lives above the SMA(9) in a bull market, that we can experience news highs on regular basis.

How do I trade based on this?

Glad you came that far down in the article, if you directly jumped down here - fine as well. Let’s get to the real question, how can you take this approach to action. First of all, it is about routine and practice. There are an unlimited amount of strategies out there and if you believe or not quite a lot of them actually work. Identify the one that is most suitable for you, your trading style and personality. If you are the person who seeks quick gains and excitement in trading bring it down to low time frames and scalp the market. If you are a patient and not so stress resistant personality (like me ;)) choose bring your strategy up to higher time frame, aim for steady longer term trades.

“I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times.”

- Bruce Lee

No matter what trading personality you are, you can apply the strategy I tried to explain over the last lines to all time frames and all assets. To do so I follow the following steps:

1. Trend Identification: Is the asset I am looking at in a clear trend and if so what is the direction of the trend. Above we talked about the characteristics of an up- or downtrend. I consult those and treat them as a checklist to identify the trend. Be aware, markets tend to stay in sideway price action for extended times. We are looking for clear trends! Take your time to make sure a clear trend is present.

2. Identify Reversals: Once we identified a clear trend (up or down / bull or bear), we start looking for positive or negative reversals. Hidden divergences, as we learned above, are key for this. Where do RSI and price action not allign. For positive reversals we are looking for lower lows on the RSI while the price reaches a higher low. Same but the other way round, for negative reversals: RSI reaches higher highs while the price is printing lower highs.

3. Moving Averages: Two points checked. Let’s check the moving averages. Are they crossed in favor of our general trend? Bull crossed in an uptrend - nice! Bear crossed in a bear trend - check! EMA(45) sloping in the direction of the trend - great! Slope matters for moving averages. The SMA(9) might slope contrary to the trend. Now we look if the price and or RSI is living above or below the moving averages. In an uptrend I want the price and RSI being above the EMA(45), once it crossed above the SMA(9), we have a setup. Vice versa for a downtrend.

4. Price Action: Now we are looking for final confluence for our setup and also for counter indicators that contradict our setup. Within this last step we look for candlestick patterns (e.g. bullish or bearish engulfing), zones of horizontal support or resistance, fibonacci levels (if you don’t know yet, we come it another time) or trendlines. For example, I would not long into a zone of resistance, but wait for price breaking through it. Also an bearish engulfing supports a potential short setup. Price bouncing from an established trendline with a PR in an uptrend gives you more confluence for your long idea. I think you get the point. It is not necessary to apply all of them to all potential setups, but the more confluence you can get the better. Also try to challenge your ideas regularly, we all get trapped in something called the confirmation bias.

If we checked the first three points on our list and found confluence in point 4 we can move to action. Beyond the scope of this post are potential targets of a trade, stop-losses, position sizing and the risk. This is something we will tackle in other posts and it is very individual for everyone. Nevertheless, I hope this approach gives you a good insight how I use the RSI as part of a trading strategy. Before you start trading yourself, I cannot emphasize enough how important practice, your own research and backtesting is!

Final Considerations

No strategy works 100% of the time. It is about the edge and pulling the odds on your side. Confluence of more than one factor helps you to get a clear view, but don’t distract yourself with to many of the same. Therefore, I combined in this approach momentum, price action and market structure.

Always have in mind, in trading you are only responsible for yourself. No one will hold your hand and take responsibility for any potential losses, but yourself. On the other hand no one other than yourself is responsible for your profits!

Everything I write here is for educational purposes and no call to action for either long or short any kind assets. I am not a financial advisor. I am here to spread what I learned over the course of the years and help others to accomplish their endeavour to become a profitable trader.

Last but not least I am interested in your opinions so feel free to get in touch, leave a comment or drop me message here or on Twitter. Now, have a great day and enjoy yourself where ever you are!