Relative strength index (RSI): the complete guide for traders

What is the relative strength index (RSI)?

The relative strength index (RSI) is a popular momentum indicator used in technical analysis that measures the speed and magnitude of price movements. Developed by J. Welles Wilder in 1978, the RSI helps traders identify when markets might be overextended in either direction.

The RSI indicator works by comparing recent gains and losses over a specified time period, generating a value between 0 and 100. This value helps traders determine if a market is potentially:

• Overbought (typically when RSI is above 70) – suggesting prices may have risen too far, too fast
• Oversold (typically when RSI is below 30) – suggesting prices may have fallen too far, too fast

Beyond identifying overbought and oversold conditions, the RSI is valuable for spotting potential trend reversals, confirming existing trends and detecting divergences between price movement and momentum.

How to use RSI in trading

Using the RSI indicator is straightforward, even for beginners. On most trading platforms including IG's, you can activate it with a few clicks. Once added, the RSI appears in a separate window below your price chart, displaying a line that oscillates between 0 and 100.

Reading RSI signals

The traditional interpretation of RSI values is:

• Above 70: The market is potentially overbought and might be due for a pullback
• Below 30: The market is potentially oversold and might be due for a bounce
• 50 level: Acts as a centreline; movements above 50 can indicate bullish momentum, while movements below 50 can indicate bearish momentum

Some traders adjust these thresholds to 80 and 20 in strongly trending markets to reduce false signals.

What RSI tells traders

The RSI provides several key insights:

1. Momentum strength: How strong the current price movement is
2. Potential reversals: When a market might change direction
3. Confirmation: Support for other technical signals you're observing.
4. Divergence: When price and momentum move in opposite directions (a powerful signal we'll explore later)

Remember that while RSI is valuable, it works best when combined with other technical tools and fundamental analysis as part of a comprehensive trading strategy.

Understanding the RSI formula

Understanding how RSI is calculated can help you better interpret its signals. The RSI formula is:

RSI = 100 - (100 / (1 + RS))

Where RS (Relative Strength) equals the average gain divided by average loss.

Here's how to calculate it step-by-step:

1.  Select a time period (14 periods is standard but can be adjusted)
2. Calculate the average gain and average loss over this period:
   a. Average gain = Sum of gains over the period ÷ Number of period
   b. Average loss = Sum of losses over the period ÷ Number of periods (note: this is expressed as a positive number)
3. Apply the RSI formula: 100 - (100 / (1 + RS))

Practical example

Let's say you're calculating the 14-day RSI for a stock. Over the past 14 days:

• The stock had 8 up days with an average gain of 1.2%
• The stock had 6 down days with an average loss of 0.9%

Your calculation would be:

• Average gain = 1.2% × (8/14) = 0.69%
• Average loss = 0.9% × (6/14) = 0.39%
• RS = 0.69% ÷ 0.39% = 1.77
• RSI = 100 - (100 / (1 + 1.77)) = 100 - 36.1 = 63.9

This RSI value of 63.9 indicates the stock has upward momentum but hasn't reached overbought territory yet.

While understanding the maths behind RSI is helpful, most trading platforms calculate it automatically, allowing you to focus on interpreting the signals rather than the calculations.

What are the advantages and disadvantages of RSI?

Like any technical indicator, the RSI has strengths and limitations. Understanding these helps you use it more effectively in your trading strategy.

Advantages of RSI

• Simple to interpret: The 0 - 100 scale helps traders identify if the market is oversold/overbought
• Versatility: Works across different markets (forex, stocks, commodities, etc.) and timeframes
• Trend confirmation: Helps validate the strength of existing trends
• Divergence detection: Can signal potential reversals before they appear on price charts
• Filter for market noise: Smooths out price fluctuations to help identify meaningful movements

Disadvantages of RSI

• False signals: Can produce misleading signals, especially in strongly trending markets
• Lagging indicator: Based on historical price data, meaning it may not always predict future movements
• Extended extremes: Markets can remain overbought or oversold for extended periods without reversing
• Needs confirmation: Most effective when used alongside other technical indicators
• Setting sensitivity: The default 14-period setting may not be optimal for all markets or timeframes

To minimise these disadvantages, many traders customise RSI settings based on their trading style and the specific market they're trading.

RSI divergence: When price and momentum tell different stories

Earlier, we briefly mentioned divergence as one of RSI's key insights. Now let's explore this powerful concept in detail.

RSI divergence occurs when the price chart and the RSI indicator are telling different stories – they're moving in opposite directions. This disagreement between price and momentum often signals that the current trend is weakening and may soon reverse, making divergence one of the most valuable signals for anticipating potential market turning points.

Bullish RSI divergence

Bullish divergence occurs when the price makes lower lows, but the RSI makes higher lows. This suggests that while the price is still declining, selling momentum is weakening, potentially signalling an upcoming upward reversal.

How to spot bullish divergence:

1. Price makes a new low
2. RSI makes a higher low than its previous low
3. This disagreement between price and momentum suggests bearish momentum is weakening

Bearish RSI divergence

Bearish divergence happens when the price makes higher highs, but the RSI makes lower highs. This indicates that while the price is still rising, buying momentum is fading, potentially signalling an upcoming downward reversal.

How to spot bearish divergence:

1. Price makes a new high
2. RSI makes a lower high than its previous high
3. This disagreement between price and momentum suggests bullish momentum is weakening

Divergences are particularly useful because they can provide early warnings of potential trend changes before they become obvious on the price chart itself.

Practical RSI trading strategies

While RSI can be used in various ways, here are some effective strategies for incorporating it into your trading approach:

1. Trend-aligned RSI strategy

This approach uses RSI in the direction of the underlying trend to find entry points:

• In an uptrend: Look for RSI to fall to or below 30 (oversold), then recover above 30 as a potential buy signal
• In a downtrend: Look for RSI to rise to or above 70 (overbought), then fall below 70 as a potential sell signal

This strategy helps you find potential "dips" to buy in uptrends and "rallies" to sell in downtrends.

The graph above shows that the overbought signal is used to exit the trade, not to enter a short position.

2. RSI range trading strategy

When markets are moving sideways (ranging), the RSI can be particularly effective:

• Buy when RSI falls below 30 and then rises back above it
• Sell when RSI rises above 70 and then falls back below it

This strategy works well in markets that are oscillating between support and resistance levels.

The graph above shows that the oversold signal is used to exit the trade.

3. RSI divergence trading strategy

As discussed earlier, divergence can signal potential trend reversals:

• Look for bullish divergence (price making lower lows, RSI making higher lows) for potential buy signals
• Look for bearish divergence (price making higher highs, RSI making lower highs) for potential sell signals

Always confirm divergence signals with other technical indicators or price action before entering trades.

4. RSI trendline breaks

Drawing trendlines on the RSI itself can provide additional trading signals:

• RSI breaking above a downtrend line can signal bullish momentum
• RSI breaking below an uptrend line can signal bearish momentum

This approach focuses on the momentum indicator itself rather than just the overbought/oversold levels.

Remember that RSI strategies work best when combined with proper risk management techniques, including appropriate stop-loss placement and position sizing.

Trading with RSI on the IG platform

Ready to apply RSI in your trading? Here's how to get started with IG:

1. Create an account: Open a live CFD trading account with IG
2. Choose your market: Select from thousands of markets including forex, indices, shares and commodities
3. Set up your chart: Open a chart for your chosen market and add the RSI indicator:
   a. Click on the indicators button, then select "Relative Strength Index" (RSI)
   b. Or right-click on the chart, select "Indicators", then "RSI"
   c. Adjust parameters if desired (default is 14 periods)
4. Analyse the market: Use RSI alongside other technical tools to identify potential trading opportunities
5. Execute your trade: Once you've identified a signal, open a position based on your analysis
6. Manage your risk: Set appropriate stop-loss and limit levels to manage potential losses and lock in gains
7. Monitor and adjust: Keep track of your position and adjust as needed based on new RSI signals and market conditions

Key points to remember

• RSI above 70 = potential sell; below 30 = potential buy
• Always use RSI with other indicators, never alone
• Price moving opposite to RSI often signals stronger reversals
• Strong trends can keep RSI overbought/oversold for long periods
• Always use stop-losses with RSI signals

IGA, may distribute information/research produced by its respective foreign affiliates within the IG Group of companies pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Where the research is distributed in Singapore to a person who is not an Accredited Investor, Expert Investor or an Institutional Investor, IGA accepts legal responsibility for the contents of the report to such persons only to the extent required by law. Singapore recipients should contact IGA at 6390 5118 for matters arising from, or in connection with the information distributed.

The information/research herein is prepared by IG Asia Pte Ltd (IGA) and its foreign affiliated companies (collectively known as the IG Group) and is intended for general circulation only. It does not take into account the specific investment objectives, financial situation, or particular needs of any particular person. You should take into account your specific investment objectives, financial situation, and particular needs before making a commitment to trade, including seeking advice from an independent financial adviser regarding the suitability of the investment, under a separate engagement, as you deem fit.

No representation or warranty is given as to the accuracy or completeness of this information. Consequently, any person acting on it does so entirely at their own risk. Please see important Research Disclaimer.

Please also note that the information does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. Any views and opinions expressed may be changed without an update.