The Relative Strength Index (RSI) Explained : Price Analyses

The Relative Strength Index (RSI) Explained

The Relative Strength Index (RSI) is a banded momentum indicator. As part of a cohesive strategy, the RSI can help you spot overbought and oversold levels as it oscillates between 0 and 100.

Readings 70 and above indicate that buyers could soon be exhausted and sellers will take over. Once sellers are in control, they may decide to sell off their positions which could lead to a sharp decline in prices.

On the other hand, readings 30 and below indicate oversold conditions. When the RSI hits 30, buyers could be more interested in the asset’s price and start to accumulate. As more buyers join in, the higher the demand of the asset becomes.

relative strength index

Your Relative Strength Index (RSI) Quick Facts:

  • The RSI is a momentum indicator that leads price.
  • Clues can be taken from the RSI to predict future price action.
  • The indicator is calculated by dividing the average gains and losses over 14 periods.
  • Price patterns, trendline analysis, and other signals can be studied from the RSI.

Relative Strength Index (RSI) Formula and Calculation

The calculation for the RSI is below:

These calculations were taken from the Wikipedia entry on the subject.

Relative Strength Index (RSI) Signals

The first step to understanding how the RSI works is through practical examples. In this section, we’ll go over the kinds of signals generated by the relative strength index and how you can incorporate them as part of your trading strategy.

Centerline Crossover

The most basic of signals generated by the RSI are centerline crossovers. These signals occur when the RSI line moves above and below 50 on the indicator. A move above 50 indicates buying pressure that leads to higher prices, while moves below 50 indicate selling pressure that leads to lower prices.

In the above example, the RSI tightly leads price action as it oscillates above and below the centerline of 50. This shows the effectiveness of the indicator during ranging markets.

You can use the relative strength indicator for more than just spotting overbought and oversold conditions. The RSI shows you the strength of price movements. You can also spot changes in momentum using the indicator before action is seen on the chart. 

Failure Swings

Failure swings are reliable signals that occur for both overbought and oversold readings. As a signal generated solely from the relative strength index, failure swings can alert you of an impending reversal in the price trend.

relative strength index rsi failure swing top

In the above chart, we see a head and shoulders pattern together with a failure swing. Note that the RSI’s failure point was in the middle of the H&S formation that led to a price correction before trending higher.

To summarize, the RSI went above 70, broke support, and then made a lower high before completing the price pattern. This is the formula that failure swings follow.

The way to trade failure swings when they’re formed at the top is to short the security once the RSI violates its support level.

relative strength index failure swing bottom

When failure swings form at the bottom, go long at the right shoulder once it violates its resistance. An example of a failure swing formed at the bottom of a price movement is shown above.

Divergences

A common signal generated by the RSI are divergences. You can see either bullish or bearish divergences; both often foreshadow a reversal in the trend to either the upside or downside.

Divergences occur when the RSI diverges from the trend. As momentum leads price, a mismatch between the price and RSI can often lead to a new trend before it is seen on the chart.

relative strength index rsi divergence

An example of a bearish divergence is above. Here you can see that price continued to rise higher while RSI dropped off halfway through the rally. The price made a higher high while RSI made a lower high which led to a new trend of consolidation and lower prices.

If you spot a divergence between the RSI and price, be ready or a change in the price trend. The divergence won’t always immediately appear on the price chart, so it’s worth waiting for a few bars for a correction.

Something else for you to note about the RSI is its behavior in strong price trends. It’s typical to see overbought and oversold divergences during these times. The extreme readings can persist for as long as the trend is in force and do not signal an impending reversal.

The chart above for BNB/USD shows numerous overbought divergences despite trending strongly upwards. It is in these situations that the indicator becomes less useful, so we should, therefore, trust that the existing trend will remain in force to the upside.

The RSI is better suited for ranging markets when a clear trend is unapparent.

Head and Shoulders

Head and shoulders are a classic reversal pattern that can form at the top and bottom for prices as well as the RSI. The H&S pattern consists of a neckline, two shoulders, and a head. 

relative strength index rsi head and shoulders

Above you can see a W-bottom formation along with an H&S pattern on the RSI. The indicator dipped into the oversold territory before climbing higher to create a head, and then broke resistance to create a higher trend on the RSI.

Note that the head formed at the same time as the peak on the W-bottom formation.

Rectangles

Trendline analysis can be done on the relative strength index as a standalone indicator. The RSI will form similar shapes and patterns and have the same implications for price trajectory.

The simplest price pattern to memorize are rectangles that can appear in bullish or bearish varieties. Rectangles are a continuation pattern that conjoins the lows and highs as dynamic support and resistance areas.

The more peaks and lows used to form the rectangle, the longer the period of continuation.

relative strength index rsi ascending rectangle

A small ascending rectangle is above that appeared on the BNB/BTC chart during its upward ascent. Notice how the RSI dipped out of the overbought region as the currency trended higher. 

An ascending rectangle is a consolidation pattern that tells us that the trend is more likely to continue upwards than to reverse. 

Relative Strength Index and MACD Together

A popular indicator combination is to use the RSI and the MACD. Both measure momentum but their calculations and intentions are different.

The MACD helps to identify potential buy and sell zones more easily than the RSI. The RSI, on the other hand, is great for uncovering overbought and oversold conditions — which is something the MACD can’t do.

Using these indicators together can help you spot turning points in the market as well as how large your positions should be.

As always, ensure to check your other indicators such as the accumulation distribution line and pivot points before jumping in.

Relative Strength Index Day Trading

Using the RSI in a day trading setup can unveil the overbought and oversold levels in a short time span. To get the most out of the indicator for day trading, it’s recommended to use 15 minute to hourly charts to find your entry and exit points.

Keep in mind however, that day trading using the relative strength index should also be accompanied with other indicators such as pivot points, the MACD and classic chart patterns. 

Relative Strength Index Summary

The relative strength index can help you spot potential turning points in the market with overbought and oversold zones. The indicator is most useful in ranging markets and may not perform as strongly during strong trends.

Finally, the same signals that appear on the price charts can also be applied to the RSI. These signals can reinforce the weight of evidence approach to predicting price movements in the marketplace.

Matthew North

I have a passion for trading, behavioral finance, technology, travel, and writing. Contact: matthew@priceanalyses.com.