What Is RSI and How to Read It (Relative Strength Index)

The RSI (Relative Strength Index) is a technical analysis indicator developed in the late 1970s. The RSI indicator analyzes momentum by measuring the size and speed of an asset's price movements over a set period. It's one of the most popular indicators among traders. The RSI indicator is usually used together with other technical analysis indicators.

The RSI indicator was developed by J. Welles Wilder in 1978. It was introduced in his book "New Concepts in Technical Trading Systems." Wilder organized his research and experience in stock trading into mathematical formulas and indicators for traders, and many traders have referred to them ever since. The book was completed in just six months, yet it is still popular with many chart analysts and traders today.

What Is RSI and How to Read It

The RSI is also an indicator that makes it easy to spot overbought or oversold market conditions. Based on 14 periods, the RSI indicator rates the state of an asset's price on a scale from 0 to 100. An RSI reading of 30 or below means the asset's price is getting close to a bottom (oversold), while a reading of 70 or above indicates that the asset's price for that period is getting close to a top (overbought).

The RSI is a momentum indicator, a type of technical tool that measures the speed at which prices change. When momentum rises and prices go up, it shows that stocks are being actively bought in the market. When momentum continues downward, it's a sign that selling pressure is increasing.

How Does the RSI Indicator Work?

Basically, the RSI measures an asset's price changes over 14 periods (14 days on a daily chart, 14 hours on an hourly chart, and so on).

The formula for calculating the RSI is as follows. The RSI divides the average price gain over the period by the average loss, then displays the data as a value from 0 to 100.

RSI = 100 - (100 / (1 + RS))

• RS is calculated as average gain / average loss. *RS stands for Relative Strength and represents the relative strength value calculated by comparing the average gain and average loss over a specific period.
• The average gain is the average amount by which the price rose over a specific period.
• The average loss is the average amount by which the price fell over a specific period.

How to Set Up the RSI

The default RSI setting is 14 periods, but traders can change it to increase sensitivity (fewer periods) or decrease sensitivity (more periods). So a 7-day RSI is more sensitive to price movements than one that considers 21 days. Also, in short-term trading setups, you can adjust the RSI indicator to treat 20 and 80 as the oversold and overbought levels instead of 30 and 70, which helps filter out false signals.

How to Use RSI Based on Divergence

Divergence is a concept used in technical analysis. It refers to a situation where price movement and the movement of a technical indicator go in different directions.

Using the RSI based on divergence helps you identify potential oversold and overbought situations. To do this, you need to understand bullish and bearish divergence.

Bullish divergence is when the RSI reading rises while the price falls. This shows that buying pressure is getting stronger even though the price is in a downtrend. It's seen as a signal that the price's downward momentum is weakening and may turn into an uptrend. So traders may consider a buy position at that point

On the other hand, bearish divergence means the RSI reading falls while the price rises, indicating that the market is losing momentum. It's seen as a signal that the price's upward momentum is weakening and may turn into a downtrend. So traders may consider a sell position at that point.

However, RSI divergence can be less reliable during strong trends. For example, in a strong downtrend, bullish divergence may appear before the price actually reaches a bottom. For this reason, RSI divergence tends to be better suited to markets with low volatility, or markets that are moving sideways or have subtle trends.

Wrapping Up

When using the Relative Strength Index (RSI) indicator, you should take into account the period setting, the levels (30 and 70), and bullish/bearish divergence. However, auxiliary indicators are never 100% accurate, and the risk grows especially when you rely on a single indicator. So to avoid false signals, you should consider using the RSI indicator together with other indicators, alongside a broader macro analysis of the market.