Essentially, Technical analysis (TA) involves the prediction of future market trends by examining the previous action. From traditional to cryptocurrency markets, most traders rely on specialized indicators and tools to analyze prior data as a way to identify the patterns of the markets, and maybe predict the next price movements.
The Relative Strength Index (RSI) is a TA indicator developed in the late 1970s as a tool that stock traders could use to examines how a stock is performing over a period of time. It is, basically, a momentum oscillator that measures the magnitude of price movements as well as the speed (velocity) of these movements. The RSI can be a very helpful tool depending on what type of trading one performs and it is widely used by many traders and technical analysts.
In 1978, a mechanical engineer named J. Welles Wilder focused his analytical training on technical trading. He began his financial career in real estate in the 1960s. After his partners bought him out of the business in 1972, he took his profit of $100,000 and began trading in the stocks market and during those years, he was searching for reliable tools to recognize profitable trends. In 1978, Wilder compiled his research and experience into mathematical formulas and indicators that traders could use when trading. The Relative Strength Index was one of those indicators.
By default, the RSI measures the changes in an asset’s price over 14 periods (14 days for daily charts, 14 hours for hourly charts, and so on). The formula divides the average gain the price has had over that time by the average loss it has sustained and then plots that strength on a settings scale from 0 to 100.
As mentioned, the RSI is a momentum indicator, which is a type of technical trading tool that measures the rate at which its price is changing. When momentum is rising, it indicates that the stock is being actively bought in the market. If momentum decreases, it is a sign that traders’ interest in the stock is slowing down.
The RSI is also an oscillating indicator that makes it easier for traders to spot overbought or oversold market conditions. It evaluates the asset price on a scale of 0 to 100, considering the 14 periods. While an RSI score of 30 or less suggests that the asset is probably close to its bottom (oversold), a measurement above 70 suggests that the asset price is near its high (overbought) for that time period and will likely fall.
Although the default settings for RSI is 14 periods, traders may choose to modify it in order to increase sensitivity (fewer periods) or decrease sensitivity (more periods). Therefore, a 7-day RSI is more sensitive to price movements than on that considers 21 days. Moreover, short-term trading setups may adjust the RSI indicator to consider 20 and 80 as oversold and overbought levels (instead of 30 and 70) so it is less likely to provide false signals.
Besides the RSI scores of 30 and 70 - which may suggest potentially oversold and overbought market conditions - traders also make use of the RSI to try and predict trend reversals or to spot support and resistance levels through the use of the so-called bullish and bearish divergences.
A bullish divergence is a condition where the price of an asset and the RSI scores move in opposite directions. So, the RSI score rises and creates higher lows while the price falls, creating lower lows. This is called a “bullish” divergence and indicates that the momentum is getting stronger despite the price downtrend.
In contrast, bearish divergences may indicate that despite a rise in price, the market is losing momentum. Therefore, the RSI score drops and creates lower highs while the asset price increases and creates higher highs.
Keep in mind, however, that RSI divergences are not that reliable during strong market trends. This means that a strong downtrend may present many bullish divergences before the actual bottom is finally reached. Because of that, RSI divergences are better suited for less volatile markets (with sideways movements or subtle trends).
There are several important factors to consider when using the Relative Strength Index indicator, such as the settings, the score (30 and 70), and the bullish/bearish divergences. However, one should always keep in mind that no technical indicator is 100% efficient - especially if it is used alone. Therefore, traders should consider using the RSI indicator along with other indicators in order to avoid false signals.