Relative Strength Indicator (RSI): A Deeper Look

During trading, we must use all the possible techniques to increase the probability of winning. It's like a long challenging battle but it can be won if we play smartly.

In this chapter, I will share my thoughts on how to learn from the techniques and failures of others and derive strength.

I refer to the other traders as friends as we are part of one community and have a common goal. The common goal is to preserve our capital and be a little bit smarter as it is a zero-sum game. A loss for one is a gain for another trader. 

To be a step ahead we always have to understand the movement of the herd and plan our steps accordingly, we should buy when the security is oversold and sell when it is overbought. RSI is one such indicator that will give us proper signals to do so. RSI is a Relative Strength Indicator.

The way a large herd of people behaves in a specific scenario has remained constant over the years and hence with some surety I can say patterns repeat themselves, hence be friends with trends.

Human psychology has always been complex, when a large group of people trade each and every bit of information gets accounted for in the price action be it profitability, acquisitions, market sentiment, political factors or supply & demand scenario.

Going by the pure technical analysis, we have to be concerned only with price action and find a way to work it out to our advantage.

Familiarizing the Indicator on Chart

RSI is represented as a continuous line between the values 0<RSI<100, usually traders activate it below the price chart. It has 3 lines:

1. Upper Line: to identify an overbought condition, RSI = 70
2. Middle Line: to calibrate the movement, RSI = 50
3. Lower Line: to identify an oversold condition, RSI=30

A sharp pink colour is preferred for depicting RSI, it will help in easier identification of overbought or oversold conditions. Main idea is to identify OBOS levels, i.e. overbought and oversold situations. Generally a 14 period RSI (14) is used.

Identifying Trend Reversal

Trend reversal happens in two conditions:

1. Overbought: When the security is in the upward mooning range traders keep on buying owing to FOMO and then comes a point when suddenly it enters the overbought region, RSI >70. Trend reversal is now bound to happen, you must close your long position or enter in a short position.
2. Oversold: When the security is in the downward tanking mode, traders keep on discounting the security until it reaches the oversold condition, RSI<30. Trend reversal to the upward side is about to happen and you should close short and enter in a long position.

Application of Divergence
Similar to MACD, the rule of divergence can be applied to RSI as well for better results.

1. Bullish Divergence or Positive Divergence: When price action makes lower low and RSI makes higher low. In some cases price makes an equal low but RSI makes higher low.
2. Bearish Divergence or Negative Divergence: When price action makes a higher high but the RSI makes a lower high. In some cases price makes an equal high but RSI makes lower high.

Divergence signals the beginning of trend reversal, but there is a trap you must not fall in, it's called a reversal. In such scenarios RSI shows strong momentum by making higher high or lower low but price action does not follow, indicating a continuation of the previous trend and no reversal. Reversals are therefore also known as Hidden Divergence.

1. Hidden Bearish Divergence or Negative reversals in downtrend: price action makes  lower high, but RSI makes a higher high. Here the buyers are trying to make a sudden move to increase the price by buying more, therefore RSI enters the overbought condition but the move is not powerful enough to effect downward price movement. Hence the downward trend continues.
2. Hidden Bullish Divergence or Positive reversal in uptrend: price action makes a higher low and RSI makes a lower low. Here the sellers are trying to make a sudden move to reduce the price by selling more, therefore RSI enters the oversold condition but the move is not powerful enough to effect upward price movement. Hence the upward trend continues.

Identifying Crossover

As RSI (14) considers a larger trading period it may happen that trend reversal is not visible on the RSI line before it actually happens. Therefore we will use RSI (5) in conjunction with RSI (14) and make use of crossovers for better trades. The base should be RSI (14), RSI (5) should be used to find a quicker change in price action.

1. RSI (14) > 50 (near to 66.66/70 range)
• If RSI (5) crosses above: security is leading to the overbought region, the price may rise more
• If RSI (5) crosses below: sideways or downwards movement, a good time to sell
2. RSI (14) < 50 (near to 33.33/30 range)
• If RSI (5) crosses above: upwards movement, a good time to buy
• If RSI (5) crosses below: security is leading to an oversold condition, the price may fall more

RSI Trendlines

It’s recommended that traders should keep checking the trend by drawing a trendline, if the RSI breaks it then the price action will keep on continuing in that direction or also price reversal may happen.

Mathematical Formula

Step 1:

For each trading period UC (Upward Change) or DC (Downward Change) is calculated. To calculate the same closing price of adjacent candles is considered. Following are three scenarios:

1. Cn > Cn-1

• UC = Cn - Cn-1
• DC = 0

2. Cn < Cn-1

• UC = 0
• DC = Cn-1 - Cn

3. Cn = Cn-1

• UC= DC = 0

Step 2:

RSF (Relative Strength Factor) = EMA (UC)/ EMA (DC)

Step 3:

RSI (Relative Strength Index) = 100 - [100/(1+RSF)]

where,

• Trading Period = period between 2 adjacent price candles, i.e. Cn & Cn-1
• Cn = Closing price of the current candle
• Cn-1 = Closing price of previous candle adjacent to the current candle
• RS = Relative Strength

Word of Caution

Beware of negative reversal in a downtrend and positive reversal in an uptrend, price action doesn't always follow the direction of the RSI movement.

Trading Points

1. RSI is the normalized ratio of up-moves to down-moves, expressed in the range of 0-100. Generally a 14 period RSI (14) is used.
2. When a price has risen more than market expectation, security is in the overbought mode. It's identified as a region where RSI>70, you should enter in short and close the long position.
3. When a price has fallen more than market expectation, security is in the oversold mode. It's identified as a region where RSI<30, you should enter in long and close the short position.
4. Look for signs of bullish or bearish divergence, easy way to remember is both RSI & price action would move far from each other, trend reversal would happen in direction if RSI movement