So… What is the RSI Indicator?

The RSI Indicator, or in other words, the Relative Strength Index, is widely known in the trading community for its potential to provide insights into market momentum and prediction of possible price reversals. Yet, its true power lies in the trader’s ability to apply it correctly. Misinterpretations of its signals can lead to worse trading outcomes and should be avoided at all costs. The goal of this short article is to clarify common misconceptions, introduce optimal RSI settings, share strategies employed by professional traders, and offer practical tips for utilizing the RSI indicator effectively.

If you are a visual learner, please don’t hesitate to watch the video below 👇

Understanding the RSI

The foundation of effectively using the RSI lies in understanding what the indicator represents. Oscillating between 0 and 100, the RSI measures the velocity of price movements. Traditionally, values above 70 indicate overbought conditions, while values below 30 suggest oversold conditions. However, the RSI indicator should not be taken at face value and the traditional overbought/oversold interpretation is a bit too simplistic.

Common RSI Misconception

A widespread misunderstanding among traders is the inclination to buy in perceived oversold conditions (RSI below 30) and sell in what are deemed overbought conditions (RSI above 70). This approach overlooks the importance of understanding momentum and can lead to unproductive trades, particularly in strongly trending markets where the RSI may remain in these extreme zones for a prolonged period. Two more productive use cases are to use it to trade RSI divergence and to combine that RSI with chart patterns such as the double bottom pattern. It’s also often combined with other trading indicators such as the MACD indicator or moving averages.

RSI Trading Strategies

Strategy 1: Trading RSI Divergence

Professional traders may use divergence as an indicator of potential price reversals. Divergence occurs when the direction of the RSI and price action diverge. For example, a bullish divergence, characterized by lower lows in price and higher lows in the RSI, may indicate an upcoming uptrend. On the other hand, bearish divergence is observed when higher highs in price accompany lower highs in the RSI, potentially signaling a downtrend.

In applying divergence strategies, traders often seek additional confirmation through chart patterns, support and resistance levels, or candlestick formations to enhance the probability of a successful trade.

Strategy 2: Double Bottom Pattern with RSI

The double bottom pattern, visually forming a "W" on the chart, is a classic signal of a potential upward reversal. When this pattern coincides with a rising RSI—despite the price making two lows—it may suggest increasing bullish momentum. Traders might consider entering a trade after the price breaks above the resistance level that forms the middle of the "W".

Optimizing RSI Settings

Preferred RSI Settings

By default, the RSI is calculated based on the closing prices of candles. Adjusting the RSI to include the open, high, low, and close (OHLC) of candles can provide a smoother index that may offer a more accurate reflection of market conditions. This setting can help diminish market "noise" and clarify trend directions.

Additional Tip: Divergence Indicator on TradingView

For those utilizing TradingView, employing a divergence indicator can automate the identification of potential divergences. While beneficial, it's essential to recognize its limitations and not rely on it exclusively for trading decisions. A combination of manual analysis and automated tools can form a more robust trading approach.

Avoiding Common Pitfalls

1. Overemphasis on Extreme Levels: Traders may find that basing decisions solely on the RSI crossing over 70 or below 30 can lead to misleading signals. It's crucial to consider the broader market context.

2. Ignoring the Overall Trend: In strong trends, the RSI might remain in overbought or oversold zones longer than anticipated. Observing the general market trend alongside RSI indicators can provide more nuanced insights.

3. Overlooking Divergence: The occurrence of divergence between the RSI and price action offers valuable signals that are often underestimated by traders.

Conclusion

The RSI offers more than a simplistic view of market conditions; it provides a nuanced tool that, when applied correctly, can improve trading strategies and decisions. Understanding its underlying principles, avoiding common errors, and using concepts like divergence and pattern recognition can empower traders with enhanced decision-making. It's important to remember that no single indicator should dictate your trading actions. Employing a comprehensive approach, integrating various technical analysis tools, and adhering to sound risk management principles are key to fostering trading proficiency.