Many traders use RSI to identify extreme levels in the market. RSI is often used as a mean reversion indicator to look for opportunities to "buy the dip" or "sell the rip."
What does RSI mean?
First, before you can incorporate RSI into your trading strategy, you really need to know more about the actual indicator itself.
The relative strength index (RSI) is a technical indicator of momentum that measures the speed and change of price on a scale of 0 to 100, typically over the past 14 periods.
RSI measures the strength of a security’s price change by comparing up days and down days. When the sum of gains over a number of periods exceeds the sum of losses over the same period, RSI increases.
RSI is a bounded momentum oscillator between 0 and 100. Readings above 50 are normally consistent with securities in an uptrend. Readings below 50 are bearish and consistent with downtrends.
Generally, a security is overbought when RSI is above 70 and oversold when RSI is below 30.
Traders use oversold readings to "buy the dip" and enter bullish positions.
Overbought readings above 70 may indicate a pullback is likely. However, strongly trending momentum stocks can have high RSI readings for a long time.
The midpoint in the RSI indicator is 50. The RSI midline can be used similarly as a moving average indicator. For example, a bullish cross of 50 (levels below 50 moving above 50) signals a change in trend. Like a moving average crossover signal, this change in trend can be an entry indicator.
Traders can also use the RSI midline for exit criteria. For example, a bullish investor may exit when RSI falls from 70 to 50 as the upward momentum wanes.
RSI can be used on multiple timeframes. The RSI calculation is based on the closing price for each period. So, you can use RSI on intraday, daily, weekly, or whatever timeframe chart you like.
How to trade RSI divergences
Like many technical analysis indicators, RSI is NOT a great trading signal by itself. Traders like to see some kind of divergence between price and RSI to get a valid signal.
Divergences occur when the indicator and security's price are giving mixed signals.
Typically, traders look for higher highs in price coupled with higher highs in RSI. For example, if a stock makes a new high, but RSI fails to make a new high, there is a bearish divergence between price and momentum. The price action is indicating strength, but RSI is showing fading momentum.
A failure swing is a bullish divergence where price makes a new low, but RSI fails to make a new low. Failure swings show downward momentum slowing and indicate a potential entry point.
Similar to the MACD, RSI is also used to confirm price move for a security.
Confirmation is when a security's price and an indicator are giving the same trading signal.
Traders use RSI to identify divergences between price and momentum and these signals are much more consistent (not perfect) than just simply looking for extremes. As experienced traders can confirm, RSI can stay very high or very low for a long time.
That's why divergences are so important when using RSI for trade signals.