Relative Strength Index

(RSI)
The relative strength index (RSI) is one of the most popular oscillators in all
of trading. You have likely read some general articles on the RSI in your
trading career, or have at least heard about it. However, in this post, we’ll
present four unique, profitable RSI trading strategies you can use when
trading.
Relative Strength Index (RSI)
• Using the indicator can also help predict trends, trend reversals, trend
continuations, or stagnate corrections.
Relative Strength Index Formula
The RSI was developed by J.Welles Wilder and detailed in his book New
Concepts in Technical Trading Systems in June of 1978.
The default setting for the RSI is 14 days.
You would calculate the relative strength index formula as follows:
Relative Strength =
1.25 (Avg. Gain over last 13 bars) +. 25 (Current Gain) / (.75 (Avg. Loss
over last 13 bars) + 0 (Current Loss))
Relative Strength = 1.50 / .75 = 2 RSI = 100 – [100/(1+2)] = 66.67
Finding RSI Indicator Settings
• For every platform, the settings may be different. However, most
platforms should have an RSI indicator. Once you find the RSI indicator
in your platform’s indicator index, you can edit the settings according
to whichever relative strength index trading strategy you want to
employ.
RSI Indicator Settings
• In the screenshot above, you can see inside the TradingSim RSI
settings. The default parameters are usually set for a 14 period and
80/20 upper and lower threshold.

• Within, you can change the period from the standard 14 to whatever
you prefer. You can also change the “overbought” and “oversold”
parameters as you wish. To that point, we’ll discuss different RSI
trading strategies that may require you to modify these settings.
Uptrends
• For bull markets, you want to be on the lookout for signals of 66.66
and bear markets at 33.33 [2] . You’re probably noticing that this is
slightly less than the normal 80/20 or 70/30 readings. These readings
of 33.33 and 66.66 were presented by John Hayden in his book titled
‘RSI: The Complete Guide’. John theorizes throughout the book that
these levels are the true numbers that measure bull and bear trends
and not the standard extreme readings.
Again, the RSI is not just about buy and sell signals. The indicator is
about showing “strength,” particularly as a measure of the strength
of the trend. In the above chart example, the RSI shifted from a
weak position to over 66.66. From this point, the RSI stayed above
the 33.33 level for days and would have kept you long in the
market for the entire run.
Downtrends
• As you can see below, the RSI can also define downtrends. You just
want to make sure the security does not cross 66.66
Defining Downtrend Now, should you make buy or sell signals
based on crosses of 33.33 and 66.66? Not too fast, there is more
to the RSI indicator which we will now dive into.
RSI Support and Resistance
• Did you know the RSI can display the actual support and resistance
levels in the market? These support and resistance lines can come in
the form of horizontal zones, or as we will illustrate shortly, sloping
trendlines.
Breakouts
• You may not know this, but you can apply trend lines to indicators in
the same manner as price charts. In the above chart, Stamps.com was
able to jump significant resistance on the RSI indicator and the price
chart. This breakout resulted in a nice run of over 7%.
• RSI Breakout You may not know this, but you can apply trend lines to
indicators in the same manner as price charts. In the above chart,
Stamps.com was able to jump significant resistance on the RSI
indicator and the price chart. This breakout resulted in a nice run of
over 7%.
Breakdowns
• Let’s take a look at another example. This time, the RSI was able to
call a top. In this example, the RSI had a breakdown and backtest of
the trendline before the fall in price. While the stock continued to
make higher highs, the RSI was starting to slump
• RSI Trend Breakdown The challenging part of this method is
identifying when a trendline break in the indicator will lead to a major
shift in price. As expected, you may have several false signals before
the big move. There is no such thing as easy money in the market. It
only becomes easy after you have become a master of your craft.
RSI Divergence with Price
• This is an oldie but goodie, and is still applicable to the RSI indicator.
Building upon the example from the last section, you want to identify
times where price is making new highs, but the Relative Strength
Indicator is unable to make new highs.
• RSI Divergence This is a clear example where the indicator is starting
to roll as the price inches higher.
RSI Double Bottom Signal
• The Relative Strength Index can also be used for typical patterns like
double bottoms. For the example below, the first price bottom is
made on heavy volume. This occurs after the security has been in a
strong uptrend for some period. Note that the RSI has been above 30
for a considerable amount of time. Nonetheless, after the first price
sell-off, which also results in a breach of 30 on the RSI, the stock also
has a snapback rally
• Double Bottom This rally is short lived and is then followed by another
pullback, which breaks the low of the first bottom. This second low is
where stops are raided from the first reaction low. Shortly after
breaking the low by a few ticks, the security begins to rally sharply.
Consequently, the second low not only forms a double bottom on the
price chart but the relative strength index as well. The reason this
second rally has strength is (1) the weak longs were stopped out of
their position on the second reaction, and (2) the new shorts are
being squeezed out of their position. The combination of these two
forces produces sharp rallies in a very short time frame.
Relative Strength Index Indicator
• Although the RSI is an effective tool, it is always better to combine it
with other technical indicators to validate trading decisions. The
relative strength index trading strategies we will cover in the next
section will show you how to reduce the number of false signals so
prevalent in the market.
1 – RSI + MACD
• In this trading strategy, we will combine the RSI indicator with the
very popular MACD. In short, we enter the market whenever we
receive an overbought or oversold signal from the RSI supported by
the MACD. We close our position if either indicator provides an exit
signal.
• Example This is the 10-minute chart of IBM. In this relative strength
index example, the green circles show the moments where we receive
entry signals from both indicators. The red circles denote our exit
points.
• Relative Strength Index + MACD Slightly more than an hour after the
morning open, we notice the relative strength index leaving an
oversold condition, which is a clear buy signal. The next period, we
see the MACD perform a bullish crossover – our second signal. Since
we have two matching signals from the indicators, we go long with
IBM. We appear to be at the beginning of a steady bullish trend. Five
hours later, we see the RSI entering oversold territory just for a
moment. Since our strategy only needs one sell signal, we close the
trade based on the RSI oversold reading. This position generated
$2.08 profit per share for approximately 6 hours of work.
2 – RSI + MA Cross
• In this trading strategy, we will match the RSI with the moving average
cross indicator. For the moving averages, we will use the 4-period and
13-period MAs. We will buy or sell the stock when we match an RSI
overbought or oversold signal with a supportive crossover of the
moving averages. On that token, we will hold the position until we get
the opposite signal from one of the two indicators or divergence on
the chart. First, let’s clarify something about the MA cross exit signals.
A regular crossover from the moving average is not enough to exit a
trade. We recommend waiting for a candle to close beyond both lines
of the moving average cross before exiting the market
Example
• To illustrate this RSI trading strategy, please have a look at the chart
below
• Moving Average Cross Divergence This is the 15-minute chart of McDonald’s. The
RSI enters the oversold area with the bearish gap the morning of Aug 12. Two
hours later, the RSI line exits the oversold territory generating a buy signal. An
hour and a half later, the MA has a bullish cross, giving us a second long signal.
Therefore, we buy McDonald’s as a result of two matching signals between the
RSI and the MA Cross. McDonald’s then enters a strong bullish trend, and 4 hours
later, the RSI enters the overbought zone. At the end of the trading day, we spot
a bearish divergence between the RSI and McDonald’s price. Furthermore, this
happens in the overbought area of the RSI. This is a very strong exit signal, and
we immediately close our long trade. This is a clear example of how we can
attain an extra signal from the RSI by using divergence as an exit signal. This long
position with MCD made us a profit of $2.05 per share.
3 – RSI + RVI
• For this RSI trading strategy, we’ll combine the relative strength index
with the relative vigor index. In this setup, you will enter the market
only when you have matching signals from both indicators. Hold the
position until you get an opposite signal from one of the tools – pretty
straightforward.
Example
• This is the 15-minute chart of Facebook. In this example, we take two
positions in Facebook.
• Relative Strength Index – RVI First, we get an overbought signal from the
RSI. Then the RSI line breaks to the downside, giving us the first short signal.
Two periods later, the RVI lines have a bearish cross. This is the second
bearish signal we need and we short Facebook, at which point the stock
begins to drop. After a slight counter move, the RVI lines have a bullish
cross, which is highlighted in the second red circle and we close our short
position. This trade generated a profit of 77 cents per share for a little over
2 hours of work. Facebook then starts a new bearish move slightly after 2
pm on the 21st. Unfortunately, the two indicators are not saying the same
thing, so we stay out of the market. Later the RSI enters the oversold
territory. A few periods later, the RSI generates a bullish signal.
• Relative Strength Index – RVI After two periods, the RVI lines also
have a bullish cross, which is our second signal and we take a long
position in Facebook. Just an hour later, the price starts to trend
upwards. Notice that during the price increase, the RVI lines attempt
a bearish crossover, which is represented with the two blue dots.
Fortunately, these attempts are unsuccessful, and we stay with our
long trade. Later the RVI finally has a bearish cross, and we close our
trade. This long position with FB accumulated $2.01 per share for 4
hours. In total, the RSI + RVI strategy on Facebook generated $2.78
per share.
#4 – RSI + Price Action Trading
• For this strategy, we’ll use the relative strength index overbought and
oversold signal in combination with any price action indication, such
as candlesticks, chart patterns, trend lines, channels, etc. To enter a
trade, you will need an RSI signal plus a price action signal – candle
pattern, chart pattern or breakout. The goal is to hold every trade
until a contrary RSI signal presents, or price movement confirms that
the move is over
• Price Action Trading Strategy This is the 30-minute chart of Bank of
America. The chart starts with the RSI in overbought territory. After
an uptrend, BAC draws the famous three inside down candle pattern,
which has a strong bearish potential. With the confirmation of the
pattern, we see the RSI also breaking down through the overbought
area. With matching bearish signals, we short BAC. The price starts a
slight increase afterward. Perhap we wonder if we should close the
trade or not. Fortunately, we spot a hanging man candle, which has a
bearish context. We hold our trade and the price drops again.
• Notice the three blue dots on the image. These simple dots are
enough to confirm our downtrend line. After we entered the market
on an RSI signal and a candle pattern, we now have an established
bearish trend to follow! Later on, the trend resists the price rally
(yellow circle), and we see another drop in our favor. After this
decrease, BAC breaks the bearish trend, which gives us an exit signal.
We close our position with BAC, and we collect our profit. This trade
made us 20 cents per share