Relative Strength Index

Technical analysis (TA) is essentially the practice of examining previous market events in an attempt to predict future trends and price action. From traditional markets to cryptocurrency markets, most traders rely on specialized tools to perform technical analysis, and RSI is one of them.

The Relative Strength Index (RSI) is a TA indicator that emerged in the late 1970s as a tool that allows traders to examine a stock's performance over a specific period of time. Essentially, it is a momentum oscillator that measures the magnitude and speed (velocity) of price movements. RSI can be a very useful tool depending on a trader's personal situation and how they trade.

The Relative Strength Index was created by J. Welles Wilder in 1978. He first proposed this indicator in his book New Concepts in Technical Trading Systems, along with other TA indicators such as Parabolic SAR, Average True Range (ATR) and Average Trend Index (ADX).

Wilder worked as a mechanical engineer and real estate developer before becoming a technology analyst. He started trading stocks around 1972, but wasn't very successful. A few years later, Wilder organized his trading research and experience into mathematical formulas and indicators that were later adopted by many traders around the world. The book was published just six months ago, and despite being a product of the 1970s, it is still referenced by many chartists and traders today.

How does the RSI indicator work?  

RSI by default measures the change in an asset's price over a 14-period period (14 days for the daily chart, 14 hours for the hourly chart, etc.). The indicator is calculated by dividing a price's average gain over that time period by the average loss it endured, and then plots the data on a scale from 0 to 100.  

As mentioned earlier, RSI is a momentum indicator used to measure the speed of price (or data) changes and is a technical trading tool. When a stock's momentum increases and its price rises, it indicates that the stock is being actively bought in the market. If momentum increases and price falls, it indicates selling pressure is increasing.

RSI is also an oscillator, making it easier for traders to detect whether market conditions are overbought or oversold. The indicator measures an asset's price over 14 periods and evaluates it on a scale of 0 to 100. An RSI score of 30 or below for an asset indicates that its price is likely close to its lowest price (oversold), and a score above 70 indicates that its price is likely close to its highest price during that period (overbought).

While the default setting for RSI is 14 periods, traders can choose to modify the number of periods to increase sensitivity (decrease periods) or decrease sensitivity (increase periods). Therefore, the 7-day RSI is more sensitive to price movements than the 21-day RSI. Additionally, when choosing a short-term trading approach, the RSI indicator can be adjusted to consider 20 and 80 as oversold and overbought levels (instead of 30 and 70), so the indicator is less likely to provide false signals.

How to use RSI based on divergence

In addition to judging by RSI scores (30 and 70) Potentially oversold and overbought market conditions, traders can also use RSI to try to predict trend reversals or discover support and resistance levels. This method is based on the so-called bullish divergence and bearish divergence.

A bullish divergence is when price and RSI scores move in opposite directions. That is, the RSI score rises, the lows rise and the price falls, resulting in lower lows. This is called a "bullish" divergence and indicates that purchasing power is increasing despite the downward price trend.

In contrast, a bearish divergence indicates that market momentum is declining despite rising prices. Therefore, the RSI score decreases, the highs fall and the asset price rises, resulting in higher highs.

But please note that RSI divergence is not so reliable when the market trend is strong. That is, when a downtrend is strong, there may be multiple bullish divergences before the price actually bottoms. Because of this, RSI divergence is better suited for markets with less volatility (sideways moves or subtle trends).

Summary

There are several important factors to consider when using the RSI, such as background , scores (30 and 70) and bullish/bearish divergence. But always keep in mind that no technical indicator is 100% valid, especially when used alone. Therefore, traders should consider using the RSI indicator along with other indicators to avoid generating false signals.