Trading with the RSI Indicator

2022-06-15 | Simpler Trading Team

Swing traders use valuable indicators that efficiently evaluate market price movements and momentum to devise winning strategies and setups. One of the most popular and proficient indicators used by a swing trader is the Relative Strength Index (RSI). 

The RSI is a prominent indicator for swing traders because they use a shorter time frame that can last from days to weeks or even months – traders need to quickly determine stock price movement and direction. In volatile markets, traders must think on their feet and verify charts before placing a trade.

What is RSI Indicator? How Traders Use It

The RSI indicator is swing traders’ most commonly used indicator to conduct their technical analysis. Traders use this indicator to identify attractive stock prices in areas that could be overbought and oversold.   

The RSI is a momentum oscillator that fluctuates, usually from 0 to 100. RSI is used primarily to determine whether a stock price is overbought or oversold by calculating the average gain and loss over a defined period.

As with other oscillators, the RSI is most helpful in non-trending markets. Stock price movements are based on buying and selling volume and even the overall mood of the broader market.

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How to Determine a Stock’s Fair Price?

How do traders benefit from using RSI? We could compare the price of a stock to that of a cup of coffee. Just how much is that cup of coffee really worth? As with stocks and coffee, beauty is in the eye of the beholder. It’s safe to say that our coffee could be overpriced and overbought.

RSI detects reversion to the mean

The RSI helps traders indicate if a stock is overbought or oversold, giving traders a “fair price” – or the mean price of a stock. Traders constantly look for bargains in the stock market, and one thing they don’t want to do is pay too much for a position. When traders pay too much for an overvalued stock, this can have crushing results if the stock price reverts to the mean at an inopportune time.

At Simpler Trading, it’s common to use the RSI for market analysis to consider the relative strength as a bullish indicator when it moves above the horizontal 30 reference level. Conversely, when the RSI dips below the horizontal 70 reference level, this is then viewed as a bearish indicator.

This means the RSI has factored in the upper and lower price ranges to generate a value that tends to work for everybody. This is because overbought stocks tend to reverse their upward trends and revert to the mean once the demand has petered out or a catalyst has inspired a reversal. 

Traders generally refer to specific values for overbought and oversold measurements: 

  • Overbought: 70
  • Oversold: 20

Some assets are more volatile and have much quicker price movements, making the indicator even more valuable as traders determine the mean price.

The RSI is a workhorse for swing traders as it helps detect oversold and overbought conditions. These conditions allow traders to consider buying stocks that head into oversold levels and selling stocks at overbought levels.

Since swing traders attempt to make the most from the ‘swings’ in the financial markets that can occur with volatility and uncertain market conditions, swing traders usually hold their positions for a few days to a maximum of a few weeks to allow these setups to fall into place. However, the setup can be longer if the market conditions are acceptable.

Should a stock price fall below the mean price, traders can consider using the RSI to determine whether buying a stock at that lower price is a solid strategy.

How Do Traders Use RSI?

There are several popular methods for swing traders to use the RSI in their trading routine. One of them is that the RSI can detect a reversion back to the mean price of a stock. 

We can consider that when the value of a financial instrument rises too much, too fast –  the stock price can be referred to as overbought. It makes sense that when a stock price drops suddenly, its possibility of being oversold is worth considering.

In both cases, the markets often react by a trend reversal to correct the prices. In the case of an overbought condition, the market prices stand poised to make a downward reversal trend. The market prices are poised to have an upward reversal trend for stock prices in an oversold conditions. Because of this tendency, traders sometimes can take advantage of mean-reversion trading.

While this often happens, traders can’t assume that the stock or asset price will revert to the mean price – as sector rotation, earnings, or interest rate hikes could all be at play in the broader market.

The RSI indicator works alongside other indicators and technical signals to detect when the market is poised for a reversion back to its mean. Traders often pair up the Ready. Aim. Fire!® Pro, also known as the RAF! Pro, alongside the RSI, further identifies trend reversals and reversions back to the mean. The RAF! Pro is designed to identify reversals, give traders an early warning as a turning point approaches, and provide a three-step process for timing trades. However, this refined indicator eliminates much of the “noise” that plagues other oscillators. It’s a versatile tool that helps traders pick entries and exits during trend retracements.

RSI Divergence

How to Read an RSI Divergence

An RSI divergence occurs when the RSI line moves in the opposite direction of the price graph. When the RSI indicator moves in a different direction than the stock price, traders should first consider which type of divergence occurs. The divergences are classified into two categories depending on in which direction they occur:

  • Bullish Divergences – Should the RSI indicator value bottom out at an oversold reading but rise slowly as the price continues downward.
  • Bearish Divergences – A bearish divergence presents as an overbought RSI reading, followed by a lower high on the RSI indicator should the RSI indicator’s value begin its reversal before the stock price moves.

This divergence has even more substantial evidence of either overbought or oversold conditions. Should this divergence persist for an extended time, it becomes more likely the market will turn back around.

It’s important to note that a divergence in some market conditions could result in a mean reversion that does not work. In those situations, traders will better use the RSI indicator as a measure of trend strength instead.

In these cases, the RSI indicator can be used to determine a support or resistance level. Should you see certain RSI levels where the price turned around or failed to break out on a chart, traders could anticipate these areas have become areas of support or resistance.

How to Read the RSI Indicator

On trading platforms, the RSI chart is located beneath the price chart. In some instances, the RSI value is located on the chart relative to the selected stock price.

Based on the stock chart, traders can use the relative strength index to establish trading direction. The indicator allows traders to determine entry signals and exit points. Low relative strength index levels (below 20) generate buy signals. High RSI levels (above 70) generate sell signals. 

The RSI is an effective tool, but traders should combine it with other technical indicators to validate trading decisions and reduce the number of false signals. By combining the relative strength index with indicators such as volume or moving averages, traders have more reliable information to confirm their setups. Since things rarely go as planned in the market, using more than one indicator to confirm a trend or move is a good idea. Traders should consider adding a stop loss in their trades.

In summary, the Relative Strength Index is a momentum indicator that calculates recent price movements to determine whether a stock is positioned for a rally or a selloff. It’s considered an essential indicator to many traders; the RSI, when combined with other technical indicators, allows traders to identify opportunities to enter or exit a trade.

Most importantly, traders new to the RSI indicator should test RSI trading strategies using paper trades, or trading simulators, on the trading platform. By combining technicals with an understanding of the movement of the broader market, traders improve their opportunities to hit a home run with their trades.

If you still have questions about utilizing the RSI indicator in your trading career, consider joining us in the Simpler Free Trading Room. Traders who sign up for the free trading room not only get to trade with a professional trader for free, but they can get access to the room archives and attend free classes. Sign up today and never trade alone.

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FAQs on the RSI

Q: Does the RSI Indicator provide a roadmap to reversions to the mean?

A: Indicators can’t provide black or white instructions. Traders at Simpler use the relative strength index to seek out oversold and overbought areas. The oversold price is lower, but the RSI value forms a higher low. An overbought price is higher, but the RSI value creates a lower high. The RSI readings should be confirmed with a second measurement.

Q: How can I use the relative strength index to determine whether to buy or sell?

A: Low relative strength index levels (below 20) generate buy signals. High RSI levels (above 70) generate sell signals. When the RSI surpasses the horizontal 20 reference level, it is a bullish sign, and when it slides below the horizontal 70 reference level, this is considered a bearish sign.

Q: Can any trader have success using the relative strength index?

A: The relative strength index (RSI) provides short-term buy and sell signals – which doesn’t make this a strong indicator for longer-term or position traders. If you make shorter-term trades with the intent to hold for days, weeks, or months, the relative strength index can help you evaluate which direction stocks may head over the short term.

Q: My stock price and my RSI indicator are not moving together. Is it broken?

A: Divergence occurs when prices move in the opposite direction from an indicator like an oscillator. Traders may consider divergence even stronger evidence of overbought or oversold conditions.

Q: Which time frame works best for the relative strength index?

A: The default RSI formula is calculated based on: gains over the last 13 periods, the current gain, average loss over the last 13 periods, and current loss. 

Swing traders may consider a common setting for the RSI indicator of a two- to seven-day lookback with the oversold threshold set at 30 and the overbought threshold set at 70. The inputs can be adjusted to work better with market conditions and individual trading setups.

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