RSI is short for Relative Strength Index. It is a technical analysis indicator (a Momentum Oscillator) that measures the magnitude of recent price moves to determine whether overbought or oversold conditions are present in the price of a stock. The RSI is typically measured on a scale of 0 to 100, with the default overbought and oversold levels marked at 70 and 30, respectively.
An overbought reading on the RSI is typically used to indicate that the stock is over-extended and due for a correction, while an oversold reading indicates that the stock has sold off too heavily and is due for a rally. The RSI indicator is a popular indicator among technical traders and systematic traders and is very commonly used in mean reversion trading systems and strategies.
How do you read the RSI indicator
To read the RSI indicator, first look at the scale along the side of the chart. This ranges from 0 to 100. The RSI values can then be plotted on this scale, with values above 70 indicating that a stock is overbought and values below 30 indicating that it is oversold. The chart below plots the 14 period RSI indicator on the S&P500 Index.
As you can see the RSI oscilates from 0 when the stock is extremely weak to 100 when the stock is extremely strong. The extremes can give an indication that the stock is due for a reversal, however, like all indicators in technical analysis, these signals are not perfect.
What are the best RSI indicator settings
The best RSI indicator settings will depend on the individual trader or investor and their unique trading style and objectives. In general, the default settings for the RSI, which has a 14-day period, are considered to be a good starting point for most traders. However, some traders may find that shorter or longer periods work better for them, depending on the time frame they are trading in and the type of asset they are trading.
The overbought / oversold thresholds that you use in your trading strategy will depend the lookback period you use and how selective you want your trading signals to be. For longer lookback periods your overbought / oversold extremes should be set closer to the neutral level, while for shorter term RSI lookback periods like the 2 period RSI you would need much more extreme settings.
The 2 period RSI works well with a much more restrictive 95/5 overbought / oversold levels.
The standard 14 period lookback works reasonably well with the typical 70/30 overbought / oversold levels.
The much slower 30 period RSI oscilates much closer to the neutral 50 level and so oversold levels of 60/40 are a better starting point.
As discussed in this post on optimizing a trading system the right way (link: https://enlightenedstocktrading.com/optimizing-an-amibroker-trading-system-the-right-way/), you need to find the most stable and profitable parameters for your particular trading system. This can be done by optimizing your system in Amibroker, however you need to be careful to avoid overfitting (curve-fitting) your trading system to past data.
What indicators are good alternatives to the RSI
These indicators all measure the momentum of a stock or other asset, and they can be used to identify overbought and oversold conditions.
They each rise when the strength of the stock rises and falls when the stock declines, however, they each have their own unique calculations and interpretations, so it may be worth experimenting with a few different indicators to see which ones work best for your specific trading style and objectives.
I recommend you backtest different alternative indicators using Amibroker to determine which performs best in your market and trading system.
How is the relative strength index calculated
The Relative Strength Index (RSI) is calculated with the following formula:
RSI = 100 – (100 / (1 + (average of gains over n periods / average of losses over n periods)))
To calculate the RSI, first, the average gains and average losses over the desired period (n) are calculated. The average gains and average losses are calculated by taking the sum of the gains and losses over the specified period, and then dividing by the number of periods.
Next, the ratio of the average gains to the average losses is calculated. This ratio is then added to 1, and the resulting value is used in the final step of the RSI calculation.
Finally, 100 is divided by the result from the previous step, and then subtracted from 100 to give the RSI value. This value is then plotted on a scale from 0 to 100. As dicsussed above, a high RSI value above 70 indicates that a stock is overbought, while a low RSI value below 30 indicates that it is oversold.
Of course all good charting software have the RSI indicator built in so in practice you never have to calculate this manually by hand.
Who invented the RSI indicator?
The RSI indicator was developed by J. Welles Wilder, Jr. and introduced in his 1978 book, “New Concepts in Technical Trading Systems.” Wilder was a mechanical engineer and a pioneer in the field of technical analysis, and he is also known for developing other popular technical indicators such as the average true range (ATR) and the parabolic stop and reverse (Parabolic SAR). Since it was introduced by Wilder, the RSI has become a widely used indicator among traders and investors, and it continues to be a popular tool for evaluating the strength of a stock or other asset.
Does the RSI indicator work?
The RSI indicator is a popular technical analysis tool among traders and investors, but it is not a perfect tool and does not always provide reliable signals. As you can see in first image above, the RSI frequently indicates overbought during uptrends and frequently indicates oversold levels in down trends. The RSI can also produce false signals, particularly in choppy or sideways markets where prices are not trending.
Like all technical indicators, the RSI is based on past price data, and it cannot predict future price movements with certainty, however when used correctly as part of a complete trading system it can give profitable trading signals.
In general, the RSI can be a useful tool for traders and investors, but it should not be relied on exclusively when making trading decisions. It is important to use the RSI in combination with other filters and trading rules as part of a complete trading system that you have backtested to ensure it is profitabile.
When does the RSI Indicator fail
The RSI indicator can sometimes fail to provide reliable signals, particularly in choppy or sideways markets where prices are not trending. In these types of markets, the RSI can produce false signals, leading traders to take losing positions.
Additionally, the RSI can sometimes fail to capture important changes in the trend of a stock or other asset. If the stock changes direction without the RSI reaching an extreme then no signal will be given. Because the RSI is based on past price data, it cannot predict future price movements with certainty. This means that it can sometimes lag behind the market, missing key turning points and giving false signals.
Like all technical indicators, the RSI is just one tool among many, and it should not be relied on exclusively when making trading decisions. It is important to use the RSI as part of a complete backtested trading system.
When does the RSI indicator actually work?
What indicators should you combine with RSI to eliminate false signals?
Is the RSI a leading or lagging indicator?
Does the RSI work on all markets
The RSI is a widely used technical analysis indicator that is applicable to many different markets, including stocks, commodities, currencies, and cryptocurrencies. However, the RSI may not work equally well in all markets, and its effectiveness can vary depending on the type of market being analyzed and the trader’s objectives.
In general, the RSI works best in trending markets, where prices are moving in a consistent direction over time. In these types of markets, the RSI can help identify overbought and oversold conditions, and it can be used to confirm other technical analysis signals.
However, the RSI may not be as effective in choppy or sideways markets, where prices are not trending consistently. In these types of markets, the RSI can produce false signals, and it may not provide reliable signals for making trades.
In summary, the RSI can be a useful technical analysis tool in many different markets, but its effectiveness can vary depending on the type of market being analyzed and the trader’s objectives. As always, it is important to use the RSI indicator as part of a complete trading system and backtest it on your markets of interest to ensure it is profitable.
How to use the RSI in a stock trading system
To use the RSI in a trading system, traders will typically look for overbought and oversold conditions in the stock or other asset they are trading and use these RSI signals as entry and exit levels. According to the default settings, an overbought condition is indicated by an RSI value above 70 would be a sell (or shorting) signal, while an oversold condition is indicated by an RSI value below 30 would be a buy (or cover short) signal.
In a trend following or swing trading strategy, traders will look for opportunities to sell or take profits when the RSI is above 70. This is because an overbought stock is thought to be ripe for a price correction, and traders may look to cash in on their gains before the stock’s price falls. Just a warning though, the market can remain overbought for a long time during a bull market, so just exiting when it is overbought may leave a lot of profit potential on the table.
When the RSI is below 30, traders may look for opportunities to buy the stock provided the stock remains in a long term up trend. This is because an oversold stock is thought to be undervalued, and traders may look to buy the stock in anticipation of a price increase.
Traders can use the RSI in combination with other technical analysis indicators and techniques to help confirm trade signals and make more informed trading decisions. It is important to remember that the RSI is just one tool among many, and it should not be relied on exclusively when making trading decisions.
How to use RSI in a trend following trading system
- Calculate the RSI for a given security or market index.
To do this, you will need to know the price data for the security, such as the closing price for a given time period (e.g. daily, hourly, etc.). You can use a spreadsheet or trading software to do the calculation.
- Set a time period for the RSI calculation.
The default time period for RSI is 14 periods, but you can use a shorter or longer time period depending on your trading strategy. A shorter time period will make the RSI more sensitive to price changes, while a longer time period will smooth out the indicator and make it less sensitive.
- Identify overbought and oversold levels for the RSI signals starting with the default settings discussed above.
In a trend following system, you would typically buy when the RSI falls below an oversold level (e.g. 30) in an up trend and then rises above that level, indicating that the security is starting to regain momentum. You would then sell when the RSI rises above an overbought level (e.g. 70) and then falls below that level, indicating that the security is starting to lose momentum. These values should be optimized for each trading system and market to maximise the performance of your trading system.
- Use the RSI to generate buy and sell signals.
With your complete trading system you can generate your trading signals quickly and easily by running the backtest and mirroring the trades your backtest takes in your trading account.
It’s important to note that RSI is just one of many technical indicators that you can use in a trend following system, and it should not be used in isolation. It’s always a good idea to combine RSI with other indicators, such as moving averages or trend lines, to confirm the signals that it generates. Additionally, you should always use risk management techniques, such as stop loss orders, to limit your potential losses.
How to use RSI in a mean reversion trading system
The Relative Strength Index can also be used as the entry trigger or exit trigger in a mean reversion trading strategy. To use RSI in a mean reversion trading system, you would typically:
- Calculate the RSI for a given security or market index.
- Set a time period for the RSI calculation.
- Identify overbought and oversold levels for the RSI.
- Use the RSI to generate buy and sell signals. In a mean reversion system, you would typically buy when a stock first drops below the oversold level and sell when it raises above the overbought level.
Most mean reversion trading systems enter long on extreme oversold levels (such as a reading of 5 on the 14 period RSI) and exit quickly on a rally (such as a reading of 30 on the 14 period RSI). Additionally, you should always use risk management techniques, such as stop loss orders, to limit your potential losses.
Should you use a stop loss with an RSI based trading system?
Yes, it is generally a good idea to use a stop loss with an RSI-based trading system, particularly if you are using the overbought / oversold levels to enter in a countertrend fashion.
A stop loss is a risk management tool that helps to limit potential losses by automatically closing a trade when the price reaches a certain level. This can protect you from significant losses if the market moves against your position.
If you are using a mean reversion trading system it is critical that you don’t set your stop loss to close to the current price, because if you are buying weakness the price may continue to fall temporatily before rallying to your profit point. If your stop loss is set too tightly this will ruin your trading system’s profitability. As always, backtest the stop loss width in your trading system to ensure you are reaching the best tradeoff between cutting your losses short and getting hit too often.
There are different ways to use a stop loss with an RSI-based trading system. For example, you could set a stop loss at a fixed dollar amount below your entry price, or you could set a stop loss at a certain percentage below your entry price, or a certain number of Average True Ranges below your entry price. Alternatively, if you are using a trend following strategy you could use a trailing stop loss, which adjusts the stop loss level as the price moves in your favor.
By using a stop loss, you can limit your potential losses and ensure that you exit a trade if the market moves against you.
It’s important to note that a stop loss is not a guarantee that you will limit your losses. The market can gap or spike, and your stop loss may not be executed at the exact level that you set. It’s always a good idea to use a stop loss as part of a comprehensive risk management strategy, along with other techniques such as position sizing and risk management.
Are divergences in the relative strength index important
Divergences in the Relative Strength Index (RSI) can be an important signal for traders. A divergence occurs when the price of a security and the RSI indicator move in opposite directions. This can indicate that the current trend is losing momentum and may be due for a reversal.
There are two types of divergences in the RSI: bullish divergences and bearish divergences.
A bullish divergence occurs when the price of a security is making lower lows, but the RSI is making higher lows. This can indicate that the downtrend in the stock is nearing completion and may be due for a rally.
A bearish divergence is when the price of a security is making higher highs, but the RSI is making lower highs. This can indicate that the uptrend in the stock is exhausted and it is due for a correction. An example of a bearish divergence is shown on the chart of the Ford Motor Company (F) below:
How to optimize the RSI indicator in your trading system
- The lookback period
- The oversold level
- The overbought level
- The number of days below the oversold level (or above the overbought level)
- Reducing the number of paramters you are optimizing is important becuase simple trading systems with fewer parameters tend to work better in real time trading than complex sytems with many highly optimized parameter values.
Using the RSI indicator for long term trading
- Calculate the RSI for a given security or market index.
- Set a long-term time period for the RSI calculation. The default time period for the RSI is 14 periods, but you can use a longer time period, such as 21, 25 or even 30 periods, to smooth out the indicator and reduce the number of false signals. A longer time period will make the RSI less sensitive to short-term price fluctuations and can help to identify longer-term trends.
- Identify overbought and oversold levels for the RSI as discussed earlier in this article.
- Use the RSI to generate buy and sell signals. In a long-term trading system, you would typically use the RSI to identify overbought and oversold levels and then wait for the price to reverse and confirm the signal. For example, you could buy when the RSI falls below an oversold level (e.g. 30) and then rises above that level, indicating that the security is starting to gain momentum. You would then sell when the RSI rises above an overbought level (e.g. 70) and then falls below that level, indicating that the security is starting to lose momentum.