Relative Strength Index (RSI)

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What is RSI?

The Relative Strength Index (RSI), developed by J. Welles Wilder, is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between zero and 100.

The basic formula is:

RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

RSI is one of the widely used momentum indicator. If rightly used it can give you sense of direction and momentum at same time.


How not to use RSI

Traditionally the RSI is considered overbought when above 70 and oversold when below 30. Many people take short trades when it reaches 70 level considering it as overbought and long trade when it reaches 30 considering it as oversold.

But in long term this approach can prove to be costly as stock can remain overbought or oversold for longer period of time and keep moving in same direction.


In above chart we can see how Tata motor kept moving up when RSI was above 70.


RSI Secrets and various ways to use RSI

1. Using RSI for forming a view and direction of momentum of stock.

  Very simple and basic way to use RSI is for forming a view on stock. During an uptrend, the RSI typically remains above 60, reflecting the strength

of buying pressure. Conversely, during a downtrend, the RSI tends to stay below 40, signaling the dominance of selling pressure. Based on this

observation we can conclude that:

  • RSI > 60 - Bullish & Momentum on upside
  • RSI < 40 - Bearish & Momentum on downside

[People use different levels of RSI say 55, 65 or 70 . All as per your experience. but 60 is widely used number]


Option sellers can use this on option charts. when CE/PE charts are below 40, then can consider selling that option.


2.  RSI for finding Momentum

In this approach people compare RSI of different time frame on same stock for forming a view. By examining the RSI on longer and shorter

timeframes simultaneously, traders can gain a more comprehensive understanding of the prevailing trend and potential entry or exit points.

Longer timeframes [monthly / weekly] can provide us view for long term and shorter timeframses [Daily / hourly ] can provide us view for short

term.

  • RSI on higher time frame & Lower time frame > 60 - Bullish view

eg. RSI on weekly chart is above 60 level and RSI on daily chart also above 60 level - stock is bullish

 

  • RSI on higher time frame & lower timeframe <40 - Bearish

  eg. RSI on daily chart is below 40 level and RSI on 60 min chart also below 40 level - stock is bearish



3.   Breakout Trades using RSI

In this approach people use RSI on lower timeframe as trigger for entry in trade if RSI on higher timeframe is in same direction.

  • RSI on higher timeframe > 60 & RSI on lower timeframe crosses 60 level - Bullish Trade

  eg. RSI on Weekly chart is >60 and RSI on Daily chart crosses 60 - use this as trigger to enter the bullish trade

  • RSI on higher timeframe <40 & RSI on lower timeframe crosses 40 level - Bearish trade

  eg. RSI ondaily chart is <40 and RSI on 60min chart crosses below 40 - use this as trigger to enter the Bearish trade




4.  Mean Reversal Trades using RSI

If a stock's price shoots up too high, it tends to eventually fall back down to its average price. Likewise, if a stock's price drops too low, it usually

bounces back up to its average over time. This tendency of stocks is called mean reversion. Higher timeframe for forming a view and Lower

timeframe for taking entry when stock gives small move against the trend.

  • RSI on higher timeframe > 60 & RSI on lower timeframe reaches 40 level and shows reversal - can take Bullish Trade

  eg. RSI on monthly chart is above 60 and RSI on weekly timeframe reaches 40, finds support there and reverses from that level - use this

reversal for taking long trade

  • RSI on higher timeframe < 40 & RSI on lower timeframe reaches 60 level and shows reversal - can take Bearish Trade

  eg. RSI on weekly chart is below 40 and RSI on Daily timeframe reaches 60, finds resistance there and reverses from that level - use this reversal

for taking short trade



5. Spotting trend reversals with RSI [RSI Divergences]:

Using divergences between the RSI and prices on the chart is one more way to trade using RSI. This method allows to spot trend reversals at

early stage thus leading to greater profits. RSI divergence is like noticing when the speed of the stock's movement doesn't match up with the

speed of the RSI indicator, giving you a heads-up that a change in direction might be on the horizon. There are two types of divergences:

Bullish Divergence:

In given chart of Maruti we can observe that price [upper part] making Lower Low [point 1, 2 & 3], but at same time, RSI [lower part] making Higher Low [point a, b & c]. This indicates the strength and momentum of the downtrend is decreasing, which makes recovery in price more likely.

This divergence should also be confirmed by weakness in price, before taking any trade.



Bearish Divergence

In given chart of Bandhan Bank we can observe that price [upper part] making higher high [point 1 & 2], but RSI [lower part] making lower high [point 1 & 2]. This indicates the strength and momentum of the uptrend is decreasing, which makes downturn in price more likely.

This divergence should also be confirmed by weakness in price, before taking any trade.



5. Using historical Reference level on RSI chart:

Observation is greatest skill in trading. If you observe historical charts you will come to know that many a times RSI reverses from same or similar

level. You can use such levels on RSI for finding a reversal trades. two important points here are

1.  These levels would be different for each stock

  2.  Never catch a falling knife - wait for reversal/confirmation from identified RSI level.


For reliance on upside majority of reversals happen from either 82 or 72 level And on downside majority of reversals happen from either 35 or 22 level. This analysis can give good insight on likely levels of reversal for stock.


6. Trendline and pattern approach:

Many people use Horizontal lines and trendlines on RSI chart. and take trade when breakout/ breakdown on price chart is also confirmed by

breakout or breakdown on RSI chart.

Example, In given chart trendline breakdown in Hindalco is also confirmed by horizontal line breakdown on RSI chart.


7. Using RSI in combination of other indicators

RSI can also be used with combination of other indicators. In any of the following ways

1.    When both indicators jointly confirm the view

  Example

RSI & VWAP [sell only when rsi is <40 & price below VWAP]

 

2.  One indicator used for forming a view and other indicator used for entry / exit purpose

  Example

RSI & Super Trend: when rsi is > 60. Buy when price crosses super trend with SL of super trend

 

3.   Multiple Indicators Combination

  Example:

Check our youtube video on Option Selling system which combined multiple indicatos [RSI + VWAP + Open Interest]


Disclaimer:

1.        Objective of this documents is share knowledge on Indicator and not the strategy.

2.        Before using for trading please understand character of indicator and precautions to be taken while using.

3.        A great indicator is useless without proper discipline and even mediocre indicator can do the trick with strong discipline.

4.        Observe 100s of historical charts using this indicator or in combination of other indicators and see how it works. Then try to form the rules for

entry / exit and stop loss.



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