Relative Strength Index (RSI)

RSI is an oscillator developed by J. Welles Wilder Jr. It measures the strength of instrument by monitoring changes in its closing prices. It is a leading or a coincident indicator that is never a laggard.

RSI fluctuates between 0 and 100. When it reaches a peak and turns down, it identifies a top. When itI falls and then turns up, it identifies a bottom. These turns come at different levels in different markets or even in the same market, during bull and bear periods.

Overbought and oversold levels vary from market to market and from time to time. They are often drawn at 30 and 70. Some traders use 40 and 80 levels in bull markets or 20 and 60 in bear markets. RSI shows whether bulls or bears are stronger at the specific time.

RSI gives three types of trading signals. In order of importance they are: divergences, charting patterns, and the level of RSI.

1. Bullish and Bearish Divergences

Divergence between RSI and prices gives the strongest buy and sell signals. They tend to occur at major tops and bottoms show when the trend is weak and ready to reverse.

Bullish divergence gives a buy signal. It occurs when prices fall to a new low but RSI makes a more shallow bottom than during its previous decline. Buy as soon as RSI turns up from its second bottom, and place a stop-loss below the latest minor price low. Buy signals are especially strong if the first RSI bottom is below its lower reference line and the second bottom is above that line.
Bearish divergence gives a sell signal. It happens when prices rally to a new peak but RSI makes a lower top than during the previous rally. Sell as soon as RSI turns down from its second top, and place a stop-loss above the latest minor high. Sell signals are especially strong if the first RSI top is above its upper reference line and the second top is below it.

2. Charting Patterns

The classic pattern methods (trendlines, support and resistance, head-and-shoulders) work better with RSI than with other indicators. RSI often completes these patterns a in advance of prices, providing hints of likely trend changes. For example, RSI trendlines are usually broken one or two periods before price trendlines.

When RSI breaks its downtrendline, place an order to buy above the price trendline in order to catch an upside breakout.
When RSI breaks its uptrendline, place an order to sell below the price trendline to catch a downside breakout.

3. RSI Levels

When RSI rises above its upper reference line, it means that bulls are strong but the market is overbought and entering its sell zone. When RSI declines below its lower reference line, it shows that bears are strong but the market is oversold and entering a buy zone. Buy on overbought signals of lower time frame RSI only when the higher time frame trend is up. Go short using sell signals of lower time frame RSI only when the higher time frame trend is down.

Buy when RSI declines below its lower reference line and then rallies above it.
Sell when RSI rises above its upper reference line and then crosses below it.

RSI Divergence example

This is a EUR/USD H4 chart for the last decade of April 2007. Many of us at that time were in doubt whether EUR will rally to the new highs beyond its historical maximum or the bears finally stop the train.
Here we see a definite bearish divergence when prices are still climbing up but RSI makes one lower high after another.

By the way, at the end of RSI graph wee see a downtrend line breakout (classical TA chart pattern) — a second by importance group of RSI signals.

RSI gives its best trading signals when it diverges from prices. Its strongest divergences are those in which prices rise to a new high or fall to a new low, while RSI fails to cross its reference line.
RSI tends to break its trendlines ahead of prices. In addition to the ones marked, you can find several other examples on this chart where the breaking of RSI trendlines identifies turning points in the Swiss Franc. At the right edge of the chart, as soon as RSI breaks above its trendline, it will confirm a bullish divergence and give a strong buy signal.

RSI Levels example

In the «A» point RSI only slightly hit a 30% bottom reference line and reverted. The upward swing also was not long enough, though we had a chance to get some profit in case of using the moment when RSI crossed the reference from bottom to top because it's leading indicator!
Compare it to MACD Round Bottom buy signal that is so delayed that put us into losing trade in the case.

In a «B» point the RSI hit is more intense so a profit potential. Again, the MACD bars tell us nothing about the swing strength and its signal is too late to catch the very movement beginning.

A tremendous, destroying blow occurred in «B» point. RSI line hit the unusually low for this instrument and this time period level of 10% and new trend started.