The Relative Strength Index is one of the key oscillators globally used. If you turn on local or even foreign financial news and take a close look to charts shown there, the likelihood of RSI’s appearance will be very high. This indicator reflects so-called ‘momentum’ - the speed and amplitude measuring the price change.
In other words, we can analyse the strength or weakness of the current market price conditions. The indicator is based on using close prices in a certain period, which gives an opportunity to increase predictions’ time-tested efficiency.
As a result, the RSI oscillator is used everywhere - for stock indices, futures and options contracts, currency pairs and even to predict Thursday’s rain. Long story short, RSI is exactly what doctor prescribed to a poor binary options trader.
This indicator is reliable, simple and ultra-popular. The only thing to add here is how to use it in binary options trading.
We open advanced charts, choose Relative Strength Index in the ‘indicators’ box and add it to the chart.
RSI Creation History
The creator of RSI is J.Welles Wilder. That famous trader also developed another popular indicator, which is Parabolic SAR. Welles is another example of how aside people come into trading. He used to be a regular navy technician, after what he worked as a mechanical engineer for many years. But the salary, as you could imagine, was obviously too scarce, that’ why Welles was simultaneously trying to trade on the stock exchange.
Here are some of Wider’s quotes:
If you cannot deal with the motion impact - get out of trading;
Some traders were born undisciplined. Life will teach;
Any plans, strategies and systems are ruined exactly because of your emotions. That’s what you deserve (joke, he did not say the last phrase though).
He was a funny dude. Anyway, he focused on the technical analysis and managed to succeed in that sphere. His book “New Concepts in Technical Trading Systems” was published in 1978, presenting the Relative Strength Index for the first time ever.
Years passed while the RSI oscillator was just gaining popularity. Trading by RSI is still one of the basic instruments used by technical analysts. Everywhere, in any bank or investment fund. The indicator used to get several testing periods and many new application-scenarios were found.
RSI Indicator Formula
The formula is very simple and understandable for an 11-year-old school student.
RSI = 100 - 100/(1+RS) RS = average gain / average loss.
How to read RSI
We have already figured out that RSI shows the momentum, strength and amplitude of the price. The indicator is displayed on a scale from 0 to 100.
- The closer RSI is to 0 - the weaker downside price movement is; - The closer RSI is to 100 - the less active upwards price movement gets.
The default setting for the RSI period is 14 bars, i.e. days if you use the daily timeframe of the chart. This setting could be changed though.
How to use RSI
Let’s consider several basic scenarios for using the Relative Strength Index. Overbought and Oversold conditions.
According to RSI creator’s opinion, when the current price moves fast and the indicator jumps up rapidly, that means that the price is in the overbought territory and the price action will be exhausted very soon. And then it could even start falling.
The opposite statement is also fare. If the RSI dropped down, we can observe oversold conditions and it’s worth patiently waiting for the action reversal.
The levels are:
RSI is above 70 = overbought conditions;
RSI is below 30 = oversold conditions.
The chart below shows an example of RSI indicating the overbought level, after what the price reversed:
The opposite situation when RSI is in the oversold zone is shown on the chart below:
When the RSI is between 30 and 70 - that’s a neutral situation. But if it gets closer to 50 - that’s an absence of any trend at all.
Sometimes traders change the default settings from 30 and 70 to 20 and 80 - that’s not a huge issue, you can try to do that.
Any oscillator has an effective instrument - divergence - and RSI is not an exclusion. Divergence works well for any indicator including MACD, stochastic and many other oscillators. RSI has the same picture. The key importance of divergence is that the indicator is moving in the opposite direction to the price action, which points to a potential reversal.
A bullish divergence occurs when the price moves down and RSI edges up.
A bearish divergence happens when the price climbs up while RSI declines.
An example of divergence is shown below:
This is an example when we completely ignore the price itself. The only thing to monitor is the RSI. The internal (intra-border) reversal consists of 4 simple stages.
A bullish turn (for the price to reverse upwards):
RSI drops below 30 (oversold conditions);
It jumps above 30;
Then RSI bounces back down but remains above 30;
Upwards breakout leads to the trend direction’s change.
A bearish turn (for the price to reverse downwards):
RSI rises above 70 (overbought conditions).
It falls below 70.
Then RSI bounces back up but remains below 70.
Downwards breakout leads to the trend direction’s change.
Here is an example of a bearish turn:
Every trader passionately expects the price to reverse. However, it would be a mistake to consider that very divergence leads to the price reversal. It does not work like that. If a trend is really sustainable and strong, then a divergence could only confirm that. Andrew Cardwell wrote a lot about that. According to his observations, the RSI divergence can confirm the trend’s strength but not deny it. The same was as it’s shown on the daily chart below:
That proves one more time that all of the technical analysis possibilities have to be used in a trend assessment. Whereas the strong trend will be confirmed by many technical indicators but not point to an unavoidable reversal.
Learn how to determine trends. A strong trend suggests other rules than in a sideways consolidation range.
We’ve already seen the example of a divergence mentioned above. That’s when the price goes up, RSI slides lower, being completely correct regarding the upcoming reversal.
Cardwell described inverse divergences when everything is upside down:
The price edges up and RSI slides down - a sharp upside spike is possible;
The price declines while RSI climbs up - a strong downside spike is coming.
Now let’s combine RSI with a couple of popular indicators.
What happens if one of the ultra-popular technical indicator - Stochastic - is combined with another one? We’ll get Stochastic RSI, two shampoos in one bottle.
The only thing we need to feel the difference is to add all three options (RSI, Stochastic RSI and Stochastic) to the chart as shown below:
As you can see, Stoch RSI is the indicator which took best parts of both RSI and Stochastic. In fact, that’s a more comfortable and smoothed version of traditional stochastic. Actually, many experienced traders use this version of the stochastic oscillator on daily basis. It perfectly works for the 5-minutes timeframe and larger. But for the 1-minute chart, it’s better using traditional stochastic as it’s much faster.
Here comes another popular pair.
What’s the main thing in MACD? Right, the cross of its lines above or below zero. Good, smooth and confident cross. What RSI can help here with is to confirm that cross.
Two reversal candlesticks are clearly seen. A long green one which was followed by a long red candle;
RSI was delayed in the overbought zone, suggesting the price reversal.
And the price slides like on ice.
It’s enough to remember what RSI shows - momentum - the strength with which price moves. Realizing that, it would be understandable when exactly RSI will clearly confirm the MACD cross.
Take a look at how similar is the mirror situation. It happens very rarely but once you saw it - bingo.
And again, same actors are on the scene:
1. Reversal candles (long red / long green) come together. 2. MACD cross. 3. RSI which is tired of sitting in the oversold zone.
Configuring RSI is very easy. Actually, all we can change is the period which is equal to 14 bars by default. And that’s a good value which should not be changed without any special need.
Style tab allows you to change indicators’ visual style:
RSI is the line of the indicator itself;
Upper Band - colour and width of the coloured range; the value of 70 could be changed to 80;
Lower Band - same for the bottom horizontal line; the value of 30 could be changed to 20;
Background colour could also be changed.
Honestly speaking, it’s the fourth decade since Relative Strength Index does not leave traders in peace around the globe. If you went to some paid technical analysis courses, we bet they will surely tell you about RSI. Actually, this indicator is considered the best one to create market metrics and different trading strategies and systems. It only seems that RSI is simple like nose hair - in fact, impressive depth is hidden in this indicator and it’s fascinating to discover them. Don’t even think to apply RSI blindly, as for any other technical indicator. Try to experiment. Add it to the chart and watch what does it show. Don’t rush to place your bets - the train is not going anywhere. The price, its development pace, the market depth - all of that can be monitored with help of RSI.