In the last trading training article we learned what Bollinger bands are and how they work. Along with different investment strategies with Bollinger bands, we saw the great usefulness of measuring moments of volatility and lateralization in the markets. So today we are going to continue with the series of oscillator indicators analyzing the RSI.
What is the RSI?
The RSI (Relative Strength Index) is the first indicator that we will teach you in this trading training. It's called the Relative Strength Index, a momentum indicator that measures price movements. Was created by J. Welles Wilder Jr. in 1978, being one of the most used indicators since its creation. This indicator allows us to differentiate when an asset is in an overbought or oversold zone. It belongs to the class of oscillator indicators, that is, indicators that move between values ​​from 0 to 100. It also helps us define entry and exit levels in our operations, breakout confirmations or trend reversal signals. Like all indicators, the RSI can send us false signals that can play tricks on us. That is why we must coordinate the data shown by the RSI with other indicators.
How does RSI work?​​
As we have explained in the paragraph above, the RSI oscillates between 0 and 100. Overbought levels are above 70%. On the other hand, oversold levels are limited to below 30%. Then we can see the intermediate zone between the values ​​of 30 and 70, which is declared as a neutral zone. This area is where trend directions are usually determined. And finally the line shows us the path of the measured data.
Parts of the RSI indicator. Source: Tradingview.
In order to operate with this indicator, we have to observe the moments in which the values ​​that the RSI shows us. If we see that the RSI values ​​are below the level of 30, it is a good entry signal to buy said asset. On the other hand, if we see that the RSI values ​​are above 70, it is an entry signal to sell or go short on said asset. We can limit the timing of the operation to the development of the RSI line to open or close our operations.
What is Stochastic RSI?​
The stochastic RSI indicator is the second indicator that we will teach you in this trading training. This oscillator indicator measures the level of the simple RSI with its high and low ranges within a time range. It is made up of the same oversold, overbought and neutral zones, but it has two notable differences from the first. First, the formula to calculate the stochastic RSI is based on subtracting the current RSI minus the lowest, subtracting the highest and lowest RSI and taking the two figures and dividing them by 2. The second difference is that in this RSI the indicator It has two moving averages, one fast (blue line) and another slow (orange line) that help make decisions more accurately.
How does Stochastic RSI work?​​
As we have taught you with the case of the simple RSI, the stochastic RSI works in the same way but with a couple of changes compared to the first. The overbought zone is located at values ​​above 80, instead of 70. On the other hand, the oversold zone is located at values ​​below 20 and not 30. The zone that we have called neutral is comprised between values ranging between 20 and 80. Finally, the interpretation of the movements between the two averages is easy to understand.
How the stochastic RSI works. Source: Tradingview.
In situations where we see the blue line descending below the orange, it is a bearish signal. It usually occurs after reaching overbought levels. On the other hand, in situations where we see the blue line rising above the orange line, we can interpret it as a bullish signal. It usually occurs when the oversold level has been reached.
Is there any strategy in this trading training?
As in all trading training articles, we are going to show you different strategies to take advantage of this indicator for your operations. Let's review the different investment strategies with the RSI:
RSI to define supports/resistance
One of the best uses of the RSI for our operations is to be able to delimit support and resistance levels based on the levels that develop in the indicator. In a simple way, we can define supports in the price of an asset when we see the RSI below 30 (20 in the stochastic) and define resistances when the RSI exceeds 70 (80 in the stochastic).
Using the RSI to determine supports and resistances. Source: Tradingview.
Divergences between price and indicator
We can also usually encounter an event that is good to learn in our trading training to avoid being liquidated. There are times when we may find ourselves in situations where we see that an indicator may be telling us that the price could go down. But instead of descending, it continues rising to higher levels. It can also be applied the other way around, if the indicator indicates purchases and the price continues to decline. These situations are divergences between the price and the indicator. They usually generate good trend reversal signals, although there are cases that are much more difficult to detect. As we see in the graph below, when the RSI marked a bottom and began the upward movement, it later slowed down again in the same area. At the same time, we can also see how the resistance has not managed to be decisively crossed either.
Divergences can indicate an imminent trend change. Source: Tradingview.
Applying Bollinger Bands to the RSI
At the previous article on trading training, we talked to you about Bollinger bands. Along with the explanation of the origin and use of the indicator, we teach you strategies to use the indicator. Among them, that of the double Bollinger bands. If we apply the double Bollinger bands on the RSI with the following configuration, we will be able to clearly see where the asset is at. The upper band (green line) when broken enters an uptrend. The intermediate ones (yellow lines) represent the zone of indecision, where trend reversals occur. Finally, the lower band (red line) marks the entry into a bearish trend.
Use of Bollinger bands in the RSI indicator. Source: Tradingivew.
Draw guidelines in the RSI
We always draw guidelines to better visualize the direction in which an asset is located. We can determine the price direction by joining two price points with a guideline. If we observe that it continues with the third touch, it may be a confirmation of the trend or a break in it. We can also apply this logic with the RSI indicator:
Bearish direction marking the trend along with a divergence. Source: Tradingview.
As we see in the chart above, joining the decreasing highs of the RSI we can see a divergence with the price, which continues to mark increasing highs. Finally, when the RSI tries to break the bearish trend, it does not have enough strength, giving a valuable sell signal that starts a downtrend. In the same way it can be applied if the movement was encouraged by purchases.
Apply a moving average to the RSI
Just as we have applied the Bollinger bands to this indicator, we can also apply more indicators to it. Another of the most effective for closely monitoring the price is one that we already reported in another trading training article; moving averages. By applying a moving average to the price and another to the RSI, we can coordinate convergence or divergence of an asset. In the same way, we can also take advantage of it to determine entry or exit zones in our operations. As we see in the graph below, by coordinating the two averages in both the price and the indicator, the entry and exit signals are more precise.
Use of moving averages in price and RSI. Source: Tradingview.
Conclusions about this trading training
We have given a good review of this mythical indicator that we have all used at some point, or perhaps we are trying it in our first steps. We have seen both the configuration of the simple RSI and also that of its stochastic twin. And we can also apply the strategies of this RSI trading training to many other indicators, we just have to be able to learn to adapt our operations according to our own guidelines. and methods to be more effective and safe.