Most successful traders have honed their methods using indicators. One such indicator of interest to the pros is the relative strength index (RSI) indicator which has been helping traders make money for more than 40 years.
Pejman ZwinAuthor- 14 min read
- Published:February 22, 2023
- Views:330
If you want to become a successful trader, knowing your way around this indicator is a must. So let’s dive into all the essentials that you need to make money with the RSI indicator.
J, Welles Wilder Jr. changed the trading world forever when he introduced the relative strength index indicator (an oscillator indicator) in his book New Concepts in Technical Trading Systems, published in 1978.
To summarize, Welles Wilder stated that the relative strength index is a momentum indicator that shows the buyers’ and sellers’ percent ownership of the market on a scale of 0 to 100%.
To better understand the RSI indicator, let’s imagine ourselves as a driver in a rally match and the RSI as the engine round per minute (RPM), with the price chart as the road.
During this rally, the mentioned RPM mostly ranges around 50, but occasionally when we want to rally up a hill, it might increase from 30 to 70 or even more. Driving down a hill requires no gas pedal, so the RPM drops from 70 to 30 or even less. Keep those numbers in mind.
As we can find rally direction with RPM, we also can find the market’s potential direction with the RSI indicator. Moreover, RSI helps us find overbought and oversold areas. This, in turn, provides traders with supreme buy/sell opportunities.
First, let’s discuss what RSI defines and how you can make thousands of dollars using the RSI signals in my trading strategy.
What is the relative strength index (RSI)?
An experienced rally driver knows both the roads and the proper RPM for each well. A trader is no different; to win the race using the RSI tool, he must understand what RSI is and what it defines.
With proper knowledge of the RSI formula, what each RSI number means, and OB & OS areas, RSI will be the most relied-on tool in your trading toolkit. The relative strength index is a leading indicator, meaning that it uses data collected in the past to measure possible future market movement.
Don’t worry too much about the math involved; advanced trading platforms such as TradingView will do all the work for you and show the final results in a graph, which you can usually find below the price chart.
The RSI formula, by default, first collects the last 14 candlesticks of the given timeframe. This is called the RSI length, which can be set to any number. Increasing the RSI length of candles gives the RSI a lower frequency (fluctuations), whereas decreasing it gives it a higher one.
Then, the formula divides the average green candle of the length by the red candle and calls it the relative gain (RS), or market gain. J, Welles Wilder Jr. divided 100 by (1+RS), then subtracted the result from 100, calculating the RSI percentage; a low of zero percent and a high of a hundred percent.
The 100% RSI is every bull’s dream; it shows a market in which all participants are buyers and the reverse for zero percent. That is not realistic, however; in every market, there are always buyers and sellers, and even one exception in the prior example stops the RSI from reaching zero or 100%.
Remember the 30, 50, and 70 RPM in the rally example? Well, here we also have these numbers. They divide the chart into three areas. The 70 to 100% zone is called the overbought, 50 to 70% and 30 to 50% is called neutral, and finally, 0 to 30% is called the oversold. In real market examples, RSI mostly ranges in the neutral areas between 70 and 30.
Occasionally when the price wants to go up the hill, the RSI rallies from 30% to above the 70% line. After each uptrend, the road (price) usually stabilizes, so the RSI doesn’t stay above the 70% line for long. After going uphill, we must go downhill. In a downward rally, the RSI falls from 70% to 30% or lower. RSI does not stay in the oversold area long; the same goes in the overbought.
But what do overbought and oversold mean? Let’s clarify before we continue. These two words are deceiving, and often misunderstood. Above 70% RSI line is the overbought area with more bulls than bears. So overbought simply means there are more buyers than sellers in this area. If the RSI stays above 70%, the price can have an upward potential.
The opposite happens for the oversold area, with more bears (sellers) and downward price potential. Amateur traders might see the upward breakout of the 70% line as a long signal; however, we never get buy/sell signals entering the overbought or oversold areas. In the next section, I’ll discuss how you should use RSI for buy and sell signals.
How to use the relative strength index?
To have a tool in your toolbelt is one thing, but to use it properly is another. The RSI indicator is a tool that provides reliable buy and sell signals, but not all signals are valid.
We need to make sure a signal is valid and reliable so that we can open a confident position and profit from it. When you want to drive up a hill, you push the gas pedal and start increasing your engine RPM.
The same applies to the price and the RSI graph. For a buy signal, the RSI must break the 30% line upward, hinting at the bear numbers dropping and bulls increasing. If the RSI graph continues going up and also breaks the 50% line, it is a much stronger signal for a bullish rally.
Breaking the 50% line upward means that after a bear-dominant period in the oversold area, bears are leaving the market, and bulls are replacing them. In a rally race, every hill upward is followed by a downward slope.
When you are in a downward rally, to better control your car you don’t use the gas pedal – the engine RPM drops. RSI sell signals also appear when the RSI starts to drop, more accurately, when it breaks the 70% line downward from the overbought area.
This translates into bulls leaving the market while bears enter. A stronger case scenario of this happens when the RSI continues dropping and breaks the 50% line downward also. This means that so many bears replaced bulls that their numbers are almost equal.
The initial signals (when breaking the 30 and 70% lines) differ in strength; some are weak and others are strong. The longer RSI stays in the overbought area and the closer it gets to 100% before a downward breakout of 70%, the stronger the sell signal.
Conversely, the longer RSI stays in the oversold area, and the closer it gets to 0% before the 30% line upward breakout, the stronger the buy signal.
Unlike the 30 and 70% lines, the 50% line can work as a resistance line for upward-going and a support line for downward-going RSI graphs. Whenever the 50% line rejects a coming RSI graph, you can see a minor peak/valley in the price chart as a result.
Failure Swing is a trading method that uses 50% rejects to its advantage, and positions opened with this method have a higher chance of success. In this method, first, the graph must break the 30% line upward or the 70% line downward. Then, the 50% line rejects the RSI graph once or more before an eventual breakout.
When a valid breakout of the 50% line happens, we open a position in the direction of the breakout. This way, our trade is more likely to win. To predict if the RSI graph hits or breaks the 50% line for a stronger position, you can use various methods.
One way is to use technical analysis tools such as trendlines, as well as harmonic and classic patterns on the RSI graph. In general, you can deploy patterns and technical tools that are used to analyze candlestick charts on the RSI graph.
Another trick to rate the buy and sell signals is to look at charts with higher time frames and use the bigger trend to our advantage. This is called the multi-timeframe strategy.
In the multi-timeframe strategy, after finding the bigger trend on higher time frames, we take a look at lower time frames 4 to 6 times smaller. For example, consider the 4-hour chart and the 1-hour chart. The 4-hour chart is called the trend timeframe, and the 1-hour chart is called the trading time frame.
We next look for RSI buy/sell signals in the trading time frame, and remember those signals that are in the same direction as the bigger trend have a higher winning chance; use them to enter a position and the ones against the bigger market direction as your exit.
Now that we know all the basics, it is time to discuss strategies. Follow more to find out how profitable RSI strategies can truly be.
The relative strength index trading strategies
To make money in the financial market, having a strategy is like having a map in a rally race. Without proper strategies, you get lost in charts, not knowing when to enter and when to exit.
Sometimes, the default RSI indicator is not enough for proper buy and sell signals. In this section, I’ll share with you the simplest RSI strategies you can use to make the same $15000 that, as of now, I’ve made with my BTC long position.
While trading, you must have your own personal strategy. As Morris Chang said, “Without a strategy, execution is aimless. Without execution, strategy is useless”. You learned the failure swing and multi-timeframes strategies, but those only work when a single default RSI gives enough signals to enter or exit the market.
In some extreme cases, the RSI stays in overbought or oversold areas and doesn’t return to the neutral zone for buy or sell signals. In such cases, you can use the slow and fast RSI strategy. In this strategy, we remove the 14-length RSI and add one slow 20-length RSI and one fast 10-length RSI.
With the fast and slow RSIs added, If the fast RSI goes up and crosses the slow RSI upward, it counts as a buy signal. On the other hand, if the slow RSI goes down and crosses the fast RSI downward, it counts as a sell signal. If you have ever found an RSI length with better backtest results, I would be delighted if you share it with me. Sharing dollars is caring.
Bear in mind that you also can add the multi-timeframe method to this strategy and validate only those signals that are in the direction of the bigger market trend.
Make sure to fasten your seatbelt as you drive and set your stop loss above the last peak for short positions and below the last valley for longs. Okay, you’ve waited long enough – let’s talk about the open trade of mine that has made me a sweet profit of $15000 so far.
Trade Experience
Days ago, I was watching the BTC 4-hour chart (BTC/USDT) downward trend when I noticed an inverted head and shoulder pattern, a classic reversal pattern, forming at the support zone. With the pattern neckline drawn, I added a simple moving average (SMA 60) indicator to the chart to find the trend line.
Afterward, the price closed above the SMA 60, went up a bit, but came back down later and touched both the neckline and the SMA 60 graph. At that moment, I noticed a very famous candlestick pattern on the chart: the bullish engulfing candlestick pattern.
With two RSI indicators added, one slow (length=20) and the other fast (length=10), I received a buy signal from the two RSIs crossing each other upward. That was it: I had enough clues to a bullish upward trend. I opened my long position just after the signal at $16880 and placed my stop loss below the last minor pivot (below the neckline) at $16630.
To take my profit, I waited for a red candle to drag the price down and close below the SMA 60, so I could exit afterward. As it stands now, my long position is still open, and I have earned more than $15000!
Who knows, the price might go even higher and put a much bigger smile on my face. I hope to see you guys make 5 to 6-figure profits in a matter of days, just like me, and many others.
A wonderful serenity has taken possession of my entire soul, like these sweet mornings of spring which I enjoy with my whole heart. I am alone, and feel the charm of existence in this spot, which was created for the bliss of souls like mine. I am so happy.
my dear friend, so absorbed in the exquisite sense of mere tranquil existence, that I neglect my talents.
I feel that I never was a greater artist than now. When, while the lovely valley teems with vapour around me, and the meridian sun strikes the upper surface of the impenetrable foliage of my trees, and but a few stray gleams steal into the inner sanctuary.