Relative Strength Index (RSI)

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In this lesson we talk about a very important indicator. The rsi. RSI, or relative strength Index is a momentum oscillator. This means it measures the speed and change of price movements in a market. RSI helps traders identify potential buy and sell opportunities based on market momentum.

[00:00:21.04] - Speaker 1
It is usually placed at the bottom of the chart and measures the rate of price change. Lets look at the formula to calculate the indicator. The first step in calculating RSI is to determine the average gains and losses over a specified period, typically 14 days. For each day, we calculate the difference in price from the previous day. If it's a gain, it goes into the average gains bucket.

[00:00:47.01] - Speaker 1
If it's a loss, it goes into the average losses bucket. Once we have the average gain and the average loss, we calculate the relative strength or rs. It's the ratio of average gain to average loss. Now the RSI formula comes into play. The RSI is calculated as 100 minus 100 divided by 1 plus RS.

[00:01:10.08] - Speaker 1
This formula transforms the RS into an oscillating index between 0 and 100, which is the RSI we see on our charts. The RSI can be calculated on any period, but the standard one is the 14 periods. Here we can see how you can change the period within the indicator settings in Trading view. Now let's talk about the RSI scale which ranges from 0 to 100. This scale is key to understanding market conditions.

[00:01:39.17] - Speaker 1
The indicator fluctuates on values from 0 to 100. But there are some levels that are indicative. In trading strategies. The most used reference levels are level 70 and level 30. The RSI indicator is considered a momentum oscillator used to quantify the strength or weakness of the current trend.

[00:02:00.27] - Speaker 1
The indicator tends to indicate when prices are moving towards an overbought or oversold phase. When the RSI reads above 70, it suggests an overbought market condition indicating that prices might reverse its trend. It represents a condition reached by an indicator when there is excessive upward movement in prices. When the price reaches this extreme, we can see a downward trend change. A reading below 30 suggests an oversold condition hinting that prices might rise.

[00:02:33.04] - Speaker 1
It represents a condition reached by an indicator when there is excessive downward movement in prices. When the price reaches this extreme, it we can see a trend change to the upside. The basic idea is that once these levels are reached, a reversal process is possible. Now how do traders use the rsi? Firstly, let's talk about the classic RSI strategy which is buying on oversold and selling on overbought conditions.

[00:03:00.11] - Speaker 1
When the RSI dips below 30, it suggests that the asset might be oversold and it could be a buying opportunity. When RSI goes above 70, it might be overbought, indicating a potential selling point. RSI is best used in conjunction with other technical analysis tools. For instance, combining RSI readings with trend analysis or moving averages provides a more comprehensive view of the market. It's not just about the RSI number.

[00:03:29.26] - Speaker 1
It's about understanding what the rest of the market indicators are saying. We don't use the RSI by itself, but use it as a confirmation tool in our analysis. The effectiveness of RSI signals can vary depending on the market conditions. In a strong trending market, for instance, the RSI might remain in overbought or oversold territories for extended periods. It's important to consider the overall market environment when interpreting RSI signals.

[00:03:59.26] - Speaker 1
Just because the RSI is at 30 does not mean that the market should rebound. And on the other hand, if The RSI is at 70, it does not mean that the market will crash. Let's look at some examples. The first example of using the RSI on its own. When the RSI is below 30, we are in an oversold phase and there could be interesting entry signals.

[00:04:23.02] - Speaker 1
The idea is that the price of the stock has fallen enough to attract new buyers to enter the market. In this case, we see an example on the stock baba. As we can see, we highlight possible buy entry points using this indicator alone. At the same time, if RSI is greater than 70, we are in an overbought phase and can get sell signals. Let's see in this example how the RSI gives us excellent sell signals.

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This example is on the ExxonMobil stock. However, there are many occasions when we can get false signals. In this graph we can see where the RSI indicator is below 30, signaling a long position. We would have been wrong as the stock continues its downtrend. In fact, the trend is bearish in this case.

[00:05:08.27] - Speaker 1
For this, we always use this type of indicator as confirmation and always in conjunction with other tools. A great way is to use the RSI in conjunction with other indicators. The RSI indicator is a great tool, but it has a higher value as a confirmation. Let's look at some examples. The first example is combining RSI with moving averages.

[00:05:32.21] - Speaker 1
Let's analyze the Amazon stock. The stock is in a strong uptrend and we use the 200 period simple moving average to find entry points during a pullback. As we see here, we have a possible entrance indicated by the circle. Let's use in this example the RSI and the the level below 30 to confirm my entry. The second example is through analysis of support and resistance combined with the RSI indicator.

[00:05:59.17] - Speaker 1
In this example we analyze the Under Armor stock. We can look at the historical chart and find resistance points across the red line. The RSI indicator confirms a possible short. We are above the RSI 70 level. In overbought, the price collapses.

[00:06:16.26] - Speaker 1
But in the following months it reaches a support level. The support is then tested in various points again. In this example, we use the RSI, which is near the 30 level or oversold, as confirmation. The third way of using the RSI is the confirmation of the trend. Let's look at the salesforce stock.

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We can draw a long term trend line. The third touch of the trendline starts to become significant. To increase the chances of success, we use the RSI as confirmation the RSI level is oversold below 30. We then witnessed two other long buy signals around the fourth and fifth touch of the trendline, also in this case confirmed by the RSI indicator. In the last example, we want to touch on the topic of divergence and in particular RSI divergence.

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Divergence occurs when the price action of an asset and its RSI reading move in opposite directions. And they're key indicators of potential market reversals. A divergence occurs when the direction of a price trend and a momentum indicator like the RSI don't align. Essentially, it's when the price is telling us one story and the RSI is telling us another. This discrepancy can be a powerful signal that that the current trend may be weakening and a reversal could be on the horizon.

[00:07:40.02] - Speaker 1
Now, there are two main types of RSI divergences, bullish and bearish. Let's start with the bullish divergence. This occurs when the price of an asset creates a new lower low, but the RSI forms a higher low. What does this mean? It indicates that while the price is going down, the downward momentum is losing strength.

[00:08:02.08] - Speaker 1
This weakened momentum can signal a potential upward reversal, making it a point of interest for buyers. Now let's look at bearish divergence. The opposite is true for bearish divergences. Here the price hits a higher high, but the RSI charts a lower high. This suggests that even though the price is climbing, the upward momentum is not as strong as it used to be, hinting at a possible downward trend reversal.

[00:08:29.06] - Speaker 1
This is often a signal for traders to consider selling or at least be cautious with long positions. Now, how reliable are these signals? While divergences can be insightful, they're not perfect. One common mistake traders make is acting prematurely on a divergence signal. Sometimes the market can continue in its prevailing direction for quite some time before any reversal occurs.

[00:08:53.25] - Speaker 1
This leads us to the importance of confirmation. It's key for traders to seek out additional signals or patterns that confirmed the divergence before taking action. Always look for confirmation and consider the overall market context before taking trading decisions.