The Relative Strength Index (RSI) is a momentum indicator and belongs to the same group as the MACD and Stochastic Oscillator. Like other momentum indicators, RSI is displayed in a separate window as a chart with a scale of values from 0 to 100. RSI is mainly used to identify overbought and oversold zones and find the moments of opening and closing deals, but it is also used as a divergence indicator.
RSI and Stochastic are very similar in form and content, so they can be easily confused. Both are based on the lows and highs of the price for a specific period and display oversold and overbought zones. Below is a comparison table of the two indicators. The difference between RSI and Stochastic is very subtle and lies in the difference in formulas. Stochastic is based on the ratio of the current close to a 14 day high and low range. This ratio is referred to as% K. RSI is based on relative strength, i.e. the ratio of the average rate growth to the average drop. The parameters are taken the same - highs and lows, but the formulas are different. Also, the difference is that RSI has only one line, while Stochastic has two. The second line of the Stochastic Oscillator is designated as% D and is the ordinary moving average (SMA) of% K. This is the so-called. "Signal line", which, when crossed with the main one, makes the trader know what to buy or sell. There is also a difference in the overbought and oversold range: for the RSI these are 70 and 30, for the Stochastic - 80 and 20, respectively. However, in volatile markets, the RSI is also taken at 80 and 20 to reduce the risk of false signals.
Interpreting RSI Chart
Using the default values, a rise in the RSI signal line above 70 indicates overbought, and a fall below 30 indicates oversold. A fall below 30 and a repeated breakout of this level upwards is a bullish signal, i.e. a signal to buy. The opposite situation (breakdown of the level 70 downwards) gives a sell signal.
Finding trading opportunities
Best of all, RSI determines oversold and overbought during periods when there is a certain stable trend, therefore it is used in the trending market. At the same time, in order to avoid risk and false signals, you should always trade with the trend. The technology is as follows: it is necessary to designate a trend line, and then check all buy and sell signals on it using the RSI. On an uptrend it will be a breakdown of the level 30 upwards, on a downtrend it will be a breakdown of level 70 downwards. In the chart below, the RSI crosses the overbought level several times, thus indicating a bearish signal. However, if in this case the trader began to sell against the trend, he would incur losses, since the general trend is still up. Forex trading usually does not involve responding to such small price fluctuations, which is why traders tend to always trade with the trend. You should exit a trade only when it is clear that the trend is clearly moving in the wrong direction, which is confirmed by highs or lows.
However, do not think that such bearish signals from the RSI are always false - they often do coincide with a fall, albeit a temporary one. If the RSI chart really breaks the 70 level down (and not just is in the overbought zone), you can go against the trend, but then you need to very carefully set stop-losses in case the uptrend continues. In the case of RSI, a false breakout is a breakout of the overbought or oversold level, after which the signal line goes back and does not break this level for some time. Although the breakout is called false, in fact, it is a signal for a trend reversal (false breakouts at level 70 are a signal to sell, at level 30 - to buy). During such periods, the RSI trend line is also broken, so traders mark the trend not only on the price chart, but also on the indicator.
Combination with other indicators
Since the direction of the trend is very important for using RSI, it is logical that it is used in combination with trend indicators such as moving trends or MACD. This approach is very effective, as it allows you to exclude risky and false signals and achieve maximum trading results.
Source: https://thetradable.com