RSI Is an Oscillator – Its Purpose Is to Make Things Simple
RSI (Relative Strength Index) is one of the most widely used oscillators. Oscillators are indicators calculated from price and their main purpose is… (no, not to predict the future) … to simplify our view on price action by removing the trend factor. Oscillators typically transform price information to a stationary scale with fixed limits (e.g. 0 to 100 on RSI) and therefore make it easier for traders to identify common situations in the market and make trading decisions.
Overbought and Oversold Areas on Oscillators
Most oscillators including RSI work with so called overbought and oversold areas. Market is overbought when there has been “too much” buying in the recent past (last few price bars). Conversely, an oversold market occurs when sellers have prevailed and pushed the price down.
Typical Interpretation of Overbought and Oversold Levels
Common way of looking at oscillators and their overbought and oversold areas is to think of them as a signal to trade in the other direction. As the name suggests, when market is overbought, the buying has been excessive and we can expect the price to make a downward correction or a reversal. On the other side an oversold market signals a possible increase in prices.
RSI Overbought and Oversold Level Definition
If we want to make trading decisions based on overbought and oversold levels, we must have rules defining how we will exactly identify these market conditions. On RSI (like on the other oscillators like %R or Stochastics), we define a fixed border separating both overbought and oversold area from “normal” or “neutral” market conditions. On RSI these borders are typically 20 and 80 and the interpretation is as follows:
- When RSI is between 20 and 80, the market is in the neutral area. This is the largest and quite boring part of an RSI chart. Neither buying nor selling has pushed prices to one side or the other, and recent price action has been more or less sideways.
- When RSI is greater than 80, it signals overbought market. Based on the calculation of RSI, high values of RSI occur when most of the recent bars have made higher closes (always compared to the previous bar). This typically happens in an uptrend, when the bulls have more power than the bears.
- When RSI is below 20, the market is oversold. Recent price bars have made mostly lower closes, as the bears have had more strength. The trend is down.
Using Other RSI Levels as Borders
Though the borders at 20 and 80 are the most popular, some people use 30 and 70 or 10 and 90. You can use anything you like (even 17.8 and 82.2). Generally, the lower border for oversold and higher border for overbought area you choose, the less frequently the market will get behind them and the less trading signals your RSI will give.
Trading RSI Overbought and Oversold Levels
The common approach is to buy when oversold and sell when overbought. Aggressive counter-trend traders enter immediately as soon as RSI gets below 20 or above 80. Other people wait until the original trend slows down or until RSI ticks in the opposite direction. Some traders even wait until RSI leaves the oversold or overbought area back into the normal territory.
Trend Following Strategies with RSI
However, you can also use RSI as a trend following indicator. Another way of looking at overbought market is that such market is in an uptrend – and as many people say, trend is your friend and you should trade in the direction of the trend, rather than against it.
RSI Overbought / Oversold for Exiting Trades
RSI overbought and oversold areas can also be used as a signal to exit from part or the whole position. Again, there are numerous options where to actually exit within the overbought or oversold area and what exact rules to follow.
How to Build a Trading Strategy with RSI
RSI is just one line oscillating between 0 and 100. It is very simple by itself, but provides endless possibilities regarding design of trading strategies. While the simplest trading systems which you can find everywhere in books and on the internet (and in this article) are less likely to give you consistently profitable results, you can take them as a starting point for your own research and dig deeper into RSI and its behaviour under various market conditions. Rather than a holy grail transforming rigid rules to dollar bills, RSI can be another piece in your trading puzzle.