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What is the Relative Strength Index (RSI)?

Relative Strength Index (RSI) is a technical analysis indicator calculated by comparing the closing prices of a stock or financial instrument in a given period with the previous closing prices of the base period. RSI values are illustrated as an oscillator, i.e. a line chart that moves between the two extremes.

 

How to Use RSI for Technical Analysis?

 

The importance of the RSI value for investors originates from the compatibility between the trend line of the RSI chart and the trend line of the short- and medium-term price of the financial instrument. For this reason, it is a popular indicator among investors. The RSI indicator was first introduced by J. Welles Wilder Jr. in his book New Concepts in Technical Trading Systems written in 1978.

The RSI indicator becomes even more important in short-term market analyses. In fact, the RSI value moves up or down, preceding the realisation of the price of the instrument. This way, the RSI value allows the creation of a model about the direction of the markets. This is one of those things that makes the RSI indicator valuable in terms of technical analysis.

Questions about the RSI value plague many investors who trade in financial markets. The generally accepted RSI value lies within the range of 30 to 70.

 

What happens if the RSI goes above 70?

 

If the RSI goes above 70, it is the overbought zone and is interpreted as a downward trend (sell signal).

 

What happens if the RSI goes below 30?

 

If the RSI value falls below 30, it is the oversold zone, interpreted as an upward movement of the trend (buy signal).

 

What is the RSI Formula? How is RSI Calculated?

 

Indeed, when calculating the RSI, a period / time-frame is taken as a basis. According to J. Welles Wilder Jr, known as the inventor of the RSI indicator, this period stretches over 14 days. The 14-day time-frame is also used by analysts. Surely, it is technically possible to calculate the longer-term RSI, but it should be noted that the longer the base period, the less responsive the indicators are to price movements. The RSI value, based on a shorter term, is more sensitive to price movements and thus produces a more accurate technical analysis signal.

Explaining the RSI formula in two steps, will allow us to better explain the issue. Let's first calculate RS (relative strength) and then create this RSI formula, which corresponds to a value between 0 and 100:

Calculating with the RSI formula, will generate a value in the range of 0 to 100. This value, called RSI, measures the speed of price change. The upward momentum of the RSI indicates that the financial instrument continues to be heavily bought. While a slowdown in the upward momentum of the RSI indicates that purchases for the asset have also declined.

 

Divergences in RSI Indicators

 

While performing technical analysis with the RSI indicator, another extremely important factor is the so-called RSI divergence. So, what is an RSI mismatch and how should it be interpreted? Under normal conditions, the buy or sell direction signal, which shows us the trend line formed by the calculated RSI values, is expected to be parallel to the price chart of the product. However, in some cases, the price movement of the financial instrument moves in different directions with the signal given by the RSI value. This is called an RSI divergence.

When the price of a financial instrument is in decline in an opposite direction, while the RSI indicator increases, this is called bullish divergence of the RSI. If the RSI rises while the price continues to fall, this is interpreted as a strong medium- and long-term outlook for the financial asset in question.

Negative divergence (bearish divergence) is when prices move in the opposite direction and move upwards, when the RSI is declining. With RSI, a negative divergence is interpreted as a negative outlook for the financial asset in question. Therefore, as the RSI declines, the demand for the instrument also declines. In this case, the price increase can be interpreted as the result of a temporary or manipulative factor. Bearish divergence might indicate that the asset price could enter a downward trend in the medium to long term.

 

Example of RSI Divergence

 

Suppose we have a financial asset called XYZUSD. Suppose the price of the asset has fallen to the region of 95, 92, 88, 85, 83 in recent days. And suppose the RSI value moved upwards towards the 76, 77, 79, 80, 81 zone in this period. So, we have a falling asset price trend and a rising RSI trend. These price movements can be technically interpreted as follows. The price may drop, but it may be the result of a short-term and manipulative factor. According to the RSI chart, the price of this financial instrument may rise again in the medium term.

One other thing you should know about the RSI divergence is that even though the price in the base period has risen to a level where it has not risen before, or fallen to a level where it has not fallen before, the RSI chart may not go higher/ drop lower than its previous position. If such a divergence exists, it can be interpreted as indicating that the direction of the asset will also change. In other words, when the asset price rises, this is interpreted as a falling market (sell signal), and when the asset price falls, the market starts to rise (buy signal).

Let me given an example to make this more concrete. Let the price of our XYZUSD instrument be in an upward movement along the price trajectory of 75, 77, 78, 80, 81. Let's assume that the RSI value exceeded 80 and started to create an overbought signal. Despite this sell signal from the RSI, the price of the asset continues to rise. Technically, this means that the RSI does not confirm the uptrend, signalling that the uptrend could soon be replaced by a downtrend.

 

RSI Swing Rejections

 

Price movements called RSI Swing Rejection or RSI Swing Error can generate extremely valuable analysis signals for traders. This technique examines the entry and exit movements of the RSI value into the overbought or oversold regions. Swing rejection can occur in 2 different ways:

  • Bearish Rejection
  • Bullish Rejection

 

Bearish rejection takes place in 4 stages;

 

1- RSI value drops below 30 i.e. oversold zone.

2- RSI rises above 30 again.

3- RSI drops again but this time not up to the oversold zone.

4- In its last move, the RSI rises above its latest high.

 

Bullish rejection takes place in 4 stages;

 

1- The RSI rises into the overbought zone, i.e. the RSI value reaches above 70.

2- RSI falls below 70 again.

3- RSI rises, but this rise cannot push above the threshold of 70.

4- RSI is in steep fall, dragged below its latest low.

Finally, we can mention another analysis indicator calculated based on RSI values: Stoch RSI.

 

What is Stoch RSI?

 

The concept of Stoch RSI was first mentioned in the book “New Technical Trader” written by Stanley Kroll and Tushar Chande and published in 1994.

The Stoch RSI is a technical analysis indicator that helps us understand whether an instrument is overbought or oversold, based directly on the RSI value, not the instrument's price. We would not be amiss if we called it an indicator of an indicator.

 

Stoch RSI Formula

 

Stoch RSI = (Current RSI - Lowest RSI)/(Highest RSI - Lowest RSI)

Just like the RSI, the most common time-frame for the Stoch RSI is 14 days. The Stoch RSI value for the last 14 hours can also be viewed using hourly charts.

As for the difference between Stoch RSI and Standard RSI; Stoch RSI, is a faster, more sensitive indicator, derived from the RSI. It gives traders more buy/sell signals than the RSI. This makes it a more useful tool for technical analysis. On the downside, among the many signals generated by Stoch RSI, a proliferation of false analyses may appear again. It is recommended to use the 3-day simple moving average along with the Stoch RSI to reduce the risk of these false signals.