RSI Indicator Guide: Calculation, Formula, Best Setting and Strategies | LiteFinance (2024)

This guide will explore the RSI (Relative Strength Index) indicator and its significance in trading. We will discuss the calculation and formula behind the RSI, explore the concept of the best settings for this indicator, and delve into various strategies that can be implemented using the RSI.

Whether you are a beginner or an experienced trader, understanding the RSI indicator can provide valuable insights into market trends and potential trading opportunities. So, let's dive in and explore this powerful tool for technical analysis.

Major Takeaways:

• RSI Calculation. The RSI indicator calculates average gains and losses to determine overbought and oversold conditions.

• Best Settings. Experiment with different time frames and adjust RSI parameters to suit your trading style.

• Overbought/Oversold Levels. RSI readings above 70 indicate overbought, while readings below 30 suggest oversold conditions.

• RSI Divergence. Divergence between price and RSI can signal potential trend reversals.

• Confirmation Tool. RSI can be used alongside other indicators or chart patterns for confirmation.

• RSI Strategies. RSI pullback, trendline break, and divergence strategies can be implemented for trading opportunities.

RSI Indicator Calculation & Formula

To calculate the RSI indicator, follow these steps.

Step 1:

• Calculate the range of positive and negative changes in the market price action for a specified period.

• Determine whether the period closed up or down based on the current and previous closing prices.

• If the period closed up, calculate the range of positive change as U = Price(i) - Price(i-1), and set D to 0.

• If the period closed down, calculate the range of negative change as D = Price(i-1) - Price(i), and set U to 0.

• If both closing prices are equal, set U and D to 0.

Step 2:

• Calculate the RSI between positive and negative changes. Use a Simple Moving Average (SMA) with a specified period (N) to smooth the averages of U and D.

• Divide the smoothed average of U by the smoothed average of D to calculate RS. RS is often simplified as the ratio of the average gain to the average loss.

Step 3:

• Calculate the RSI value using the formula RSI = 100 - (100 /(1 + RS)).

• Plug in the RS value to the formula to determine the RSI value.

• Note that if the denominator D in the RS formula is 0 due to a steadily rising trend, the RSI value will be 100.

Step 4:

Interpret the RSI value. RSI values above 70 are considered overbought, while values below 30 indicate oversold conditions.

RSI Calculation Excel Sheet

The RSI Calculation Excel Sheet is a tool for technical analysis that helps traders determine the strength of a security's price action. It calculates the Relative Strength Index (RSI) and allows users to plot the values on a diagram for easier interpretation.

You can download the RSI calculation Excel sheet here.

Set up and custom RSI

While most trading platforms come with default RSI settings, customizing it can help traders tailor their analysis to their individual needs. Setting up a custom RSI may seem daunting, but it's like adding toppings to a pizza - you can choose which ones you want to use based on your preferences.

Using the RSI indicator in the trading terminal

To get started, let's install the RSI indicator in the LiteFinance trading terminal.

1. Open the chart of any currency pair you're interested in, such as AUDCAD.

2. Click on the "Indicators" tab at the chart's top and select the RSI indicator.

It will appear under the price chart. By default, the RSI will analyze the last 14 candlesticks and use the close price to calculate its value. To see the custom window, click on the corresponding icon (see the screenshot below).

Now that you have the RSI indicator on your chart, let's explore what it can tell you.

1. Parameters

• Length refers to the number of candlesticks the RSI momentum oscillator analyzes to indicate the average value. The default period is 14.

• Source is the type of price that is considered in the formula. By default, the close price is the last price at which the asset was traded.

• Accuracy refers to the level values with precision to the fourth decimal place. If the parameter 0 is set, the value of the levels is 30, 70, etc.

2. Style

Style refers to the appearance of the RSI indicator on your chart. You can customize the thickness and color of the RSI line, as well as the levels and the fill color between the levels.

RSI for MT4

MT4 is a popular trading platform that you can use to trade forex and other assets. To install and configure RSI in MT4, follow these steps:

• Open MT4 and click on "Insert" in the top menu.

• Select "Indicators" and then "Oscillators."

• Choose "Relative Strength Index."

2. Open the custom window:

In the RSI settings window, adjust the following:

1. Parameters:

• Period: the number of candlesticks analyzed (default is 14).

• Apply to the price type (default is "Close").

• Style: the line thickness and color.

• Fixed minimum/Fixed maximum: Set the chart window in the level range you enter (optional).

2. Levels:

RSI levels help you identify overbought territory and oversold conditions. Here's how to set them:

• In the RSI settings window, click on the "Levels" tab.

• Enter the RSI measure you want to use as levels (e.g., 30 and 70).

• Choose the color and line style for each level.

3. Visualization:

The visualization tab allows you to set whether to show RSI on all timeframes or a specific one.

When comparing the MT4 and LiteFinance trading terminals, there are some drawbacks to using the former.

• When adjusting the settings for the RSI in MT4, you need to click on the OK button and then call up the parameters window again by right-clicking and entering the "List of Indicators - Properties" menu. This process is less straightforward than the LiteFinance terminal, where all changes to the settings are immediately displayed without the need to click OK.

• To open the settings window in LiteFinance, you simply click on the gear icon next to the chart's indicator name.

• In MT4, there is no color fill between the levels when setting RSI parameters. This feature can be helpful in visually distinguishing the different levels of the indicator.

• MT4 does not allow you to set RSI levels with the precision of a few decimals. This can be a limitation for traders who require more exact values for their analysis.

RSI for MT5

In MT5, the Relative Strength Index RSI is set in a very similar way as in MT4. To set up RSI in MT5, go to the Insert menu, click Indicators, and select RSI. However, there are a few differences in the properties window, which you can see in the image below.

RSI Trading Strategies

Here are six different RSI trading strategies that you can use to help you make better trading decisions:

1. Breakout Trading Strategy

This strategy involves drawing horizontal and diagonal levels based on the oscillator reference points. These levels help you identify potential breakout points in advance. Once the RSI indicator sends an early signal, you can use these levels to enter trades when the breakout occurs.

2. Overbought/Oversold (OBOS) Trading Strategy

The OBOS trading strategy suggests looking for trend pivot points when the market becomes overheated. There is an imbalance of buy or sell orders. When the RSI line goes above 70, it's considered overbought, and you should avoid buying the asset. Conversely, when the RSI line goes below 30, it's considered oversold, and you should avoid selling the asset.

3. Divergence Trading Strategy

This strategy involves looking for bullish or bearish divergences between the RSI line and the price chart. A bullish divergence occurs when the asset price makes new lows, but the RSI indicator makes higher lows. This indicates that the downtrend may be losing momentum, and a reversal could occur. A bearish divergence occurs when the asset price consistently makes new highs, but the RSI fails to do so, suggesting that the uptrend is losing momentum and that a reversal could be imminent.

4. Failure Swing Trading Strategy

The failure swing trading strategy is based on an M or W pattern formation on the RSI line. When this pattern occurs, it indicates that there is still some buying pressure in the market despite the price decline, and the price is likely to continue going up.

5. Cardwell's Trend Confirmations Trading Strategy

Cardwell's trend confirmation strategy involves using RSI levels shifted in the price trend line's direction. You should enter trades when the RSI indicator reverses and rebounds from strong levels. The levels for an uptrend are 40 and 80, while the levels for a downtrend are 20 and 60.

6. Cardwell's Positive and Negative Reversals Trading Strategy

This strategy is similar to divergence trading, but it's focused on positive and negative reversals. Positive reversals occur when the RSI indicator makes a higher low while the asset price makes a lower low, indicating that the downtrend is losing momentum. Negative reversals occur when the RSI indicator makes a lower high while the asset price makes a higher high, indicating that the uptrend is losing momentum.

It's important to note that the RSI indicator has some limitations, including the fact that the signals can be lagging, and the indicator may be repainted. As such, it's recommended to use RSI in combination with other technical indicators to seek investment advice and always practice proper risk and trading strategies techniques.

Potential Buy & Sell Signals

From the above chart, it is evident that the price lows align with the reference points of the RSI indicator at a level of 28. The indicator line breaks through the resistance level before the actual price reversal, providing an advance signal of the breakout. In this case, a sell signal is triggered when the oscillator breaks out of the level established based on the reference points, which is level 28.

In the RSI chart above, the reference points of the indicator, marked with red ovals, correspond with level 30. When the indicator breaks through level 30, it generates a trading signal. However, this is an early signal, and graphical analysis suggests entering the trade at the point marked with the green circle.

Note that for potentially better results, it’s recommended to zoom out the chart to get a clearer view of the bigger picture and trade in short-term timeframes, like 15 or 30 minutes.

Overbought — Oversold (OBOS) Levels

By default, the RSI's overbought conditions and oversold levels are set to 70 and 30, respectively. When the RSI line goes beyond these levels, it means the market is in an extreme condition. When the RSI line reverses in these zones, it could signal a change in the trend direction or a deep price correction. However, the trend may also go sideways, meaning there may not be any significant price movements.

To find an entry point for trading, look for when the RSI line goes back to the default range. There are two types of signals to watch for:

1. An early signal happens when the RSI turns up in the oversold territory or down in the overbought levels.

2. A primary signal happens when the RSI breaks out of level 70 from the top downward, indicating a sell signal, or if it breaks level 30 from the bottom upward, indicating a buy trade.

It's important to not strictly follow the default parameters of 30 and 70. Instead, use the 5% rule. This means finding the extreme values of the RSI for the past three months on the daily timeframe and determining if it's overbought or oversold territory for more than 5% of that time.

For example, if the RSI hasn't entered the oversold territory in the past three months, you can set a custom overbought level, say 76, on your trading chart time frame. You can then enter trades based on the same principle of waiting for the RSI to break through the strong level when it goes outside the overbought or oversold levels.

RSI Divergences

Divergence happens when the RSI and the price chart are moving in opposite directions. This can be a sign that a trend is about to change. There are two types of divergence:

• Bullish RSI divergence happens when the price goes down, but the RSI goes up.

• Bearish RSI divergence happens when the price is going up, but the RSI is going down.

If you see a bullish divergence, it could mean that the price is about to go up. If you see a bearish divergence, it could mean that the price is about to go down.

You can learn more about the divergence in this overview. RSI divergence looks like this in the chart:

When using the RSI, it's important to pay attention to the overbought and oversold zones. When the RSI is in the overbought zone (very high), it means that the price might be due for a correction or reversal. When the RSI is in the oversold zone (very low), it means that the price might be oversold and due for a bounce back up.

RSI Failure Swing: Bullish & Bearish

RSI can effectively be used with Failure Swing patterns to help traders identify potential buying or selling opportunities. The Failure Swing involves the RSI line attempting to break through a previous high or low but failing to do so. Instead, it turns back towards the median level.

The Failure Swing pattern can take on different shapes when the RSI is in the overbought or oversold zone. For example, in the overbought zone, it looks like an "M," while in the oversold zone, it looks like a "W." In both cases, the first top of the pattern is drawn in the overbought or oversold zone, and then the oscillator line turns down and breaks through a key level. The oscillator line then attempts to test the first high (or low) again, but it fails to reach the same level, creating a lower high (or higher low) that's not as clear as the first. This failure to repeat the high (or low) is a sign that buyers or sellers are losing strength.

If the RSI forms in the overbought zone and a Failure Swing pattern occurs, it could be a signal to sell or go short. Conversely, if the RSI is in the oversold zone and a Failure Swing pattern forms, it could be a signal to buy or go long. However, it's important to use additional indicators to confirm these signals and to pay attention to the trend of the market as a whole.

Cardwell’s trend confirmations

Cardwell's RSI reading trading strategy offers a different approach compared to Wilder's. In a nutshell, Cardwell suggests using different signal levels, 40 and 80 for uptrends and 20 and 60 for downtrends. According to him, a strong uptrend will not retrace to the RSI overbought zone, while a strong downtrend won't reach the RSI oversold zone. This means that the RSI indicator line should mostly move between the support and resistance levels of 40 and 60. Cardwell's trend confirmation happens when the price rebounds from these levels.

Cardwell suggests that when the RSI line is between the support and resistance levels of 40 and 60, it indicates a trend confirmation. In a bull market trend, the indicator line stays mostly between the levels of 40 and 80, with level 40 being a strong support level. On the other hand, in a bear market trend, the indicator line stays mostly between the levels of 20 and 60, with level 60 being a strong resistance level.

Let's look at an example. If the indicator line is mostly between the levels of 40 and 80, and the price bounces up from level 40, it's a strong signal to open a long position in a bullish trend. It's essential to note that you should not consider the price rebound from level 80 as a signal to enter a trade in the uptrend.

Similarly, if the indicator line is mostly between the levels of 20 and 60, and the price bounces down from level 60, it's a strong signal to enter a short trade in a bearish trend.

Positive & Negative Reversals

The positive and negative reversals technique is based on the divergences and was also introduced by Cardwell.

Positive reversals occur when the next low in an uptrend is higher than the previous low, and the next low of the Relative Strength Index (RSI) is lower than the previous correction. Despite the divergence between the price and oscillator movements, the price continues moving upwards after a brief decline, which is called inverse divergence. On the other hand, negative reversals happen when the indicator forms a higher high and the price forms a lower high, resulting in a continued market decline.

Note that positive and negative reversals are used to trade in the opposite direction of the price movement. For example, if the price is going up, but the oscillator line is moving down, it's likely that the price will jump up. Conversely, if the price is going down, but the oscillator line is moving up, the price will likely fall.

RSI Stock Screener

A stock screener is an analytical platform that offers a range of filters to sort and group shares based on specific parameters. One of the parameters that investors can use to filter stocks is technical indicators such as the RSI stock indicator. By identifying securities that are currently overbought or oversold, investors can conduct a deeper analysis to determine whether it is profitable to buy or sell a particular stock.

Read a detailed overview of screeners here.

There are different examples of screeners that investors can use, such as Investing or Finviz.

Example of successful RSI trading strategy

Let’s see a trading forex example using the EURZAR currency pair in the M5 timeframe.

Analyzing the above chart of the forex market, it’s possible to note that the price had broken through a strong resistance level in a downtrend and hadn't fallen so deep for more than ten days. This indicated that the price was likely to reverse soon, especially since the RSI with a period of 14 and signal levels of 30 and 70 was suitable for trading this pair.

If you look closer at the chart, it’s possible to notice a W-shaped failure swing pattern forming. This confirms that the price is going to reverse soon. You can wait until the indicator line breaks out level 30 from below and enter a trade.

Now it’s necessary to decide when to close the position. In this case, we can see that a trader chooses to exit the trade at the first sign of a trend reversal to avoid risks.

As it turned out, the trader was right — the trend resumed running down after a local correction, and I made a profit on the correction.

This is an example of a scalping strategy that yielded a small profit quickly. But keep in mind that there are other popular technical analysis tools you can use with the RSI, such as channel indicators or graphical analysis. You can even combine the RSI in your retail investor accounts with other oscillators like the CCI and stochastic for even more accurate signals.

Conclusion

The RSI indicator is a powerful tool for traders, providing insights into market conditions, trend reversals, and potential trading opportunities. Traders can effectively utilize the RSI in their technical analysis by understanding its calculation, best settings, and interpretation of overbought and oversold levels. Additionally, the concept of RSI divergence and its role as a confirmation tool further enhances its usefulness. Implementing various RSI-based trading strategies allows traders to capitalize on price movements and optimize their trading decisions. However, it is important to remember that the RSI should be used in conjunction with other analysis techniques and risk management strategies to make well-informed trading choices.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.