What is RSI and how do I use it?

[MC]

What does RSI stand for?
RSI is short for relative strength index.

What is the purpose of RSI?
It's aimed at predicting overbought or oversold levels and advanced traders often use it to spot divergence. We'll visit what divergence is shortly but for now let's focus on the bare indicator.

What are the common settings?
There are a few common settings which I put on the weekly charts below to show a visual difference at a glance. The most common settings are 14 and 7. A smaller group sometimes use a setting of 2, though I find it to be of less use than the longer settings in my trading.

Further details:
RSI is an oscillator which attempts to track the strength of the current price action. Some use an RSI reading of 30 to show oversold conditions, and 70 to show overbought. This is very risky, as you can see below often times these "overbought" and "oversold" levels can stay in that region for extended time while the price keeps going and going. In fact I've seen all too many times where the price enters that zone and has a violent move in the direction of the trend. I have called RSI 70 the "blast off zone" from time to time due to this phenomenon. We here at TB don't advise catching a falling knife just because RSI is at 30 or selling because an indicator is "overbought". There is no such thing as oversold or overbought, in reality price will go as low as sellers can push things or as high as bulls can rally.

What is this divergence stuff?
Divergence is best summed up as any indicator failing to make a new high or low when the price does. I've annotated the below charts to show what divergence looks like. Let me say flat out that diverging indicators in isolation mean nothing and most traders shouldn't fade (trade against) the trend without confirmation of the trend breaking down. What divergence CAN give you is a warning sign that the new price level may not be accepted or that momentum is slowing down. Also, divergence is not limited to one indicator. I use divergence techniques on RSI, volume and many other indicators.

On the first chart, the first case of bearish divergence was successful and as the trend broke down the lower strength gave way to selling pressure. The second instance had no success and the price continued on higher. This is why you wait for the trend to break to confirm the divergence before entering a trade. Only if your an aggressive trader would you take a divergence trade without confirmation, the payout could be higher but so is the risk your taking.

Another thing I want to mention is often times in the market the number 3 comes up, generally speaking. I would say if you have divergence on 3 new highs/lows the probability of that move breaking the trend is exponentially higher than a move with 2 diverging highs/lows. Not a guarantee, but being that trading is an odds game this could be the tilt of odds that makes you profitable. And again wait for that confirmation of the trend breaking down.

Below is an example of bearish divergence with 2 higher highs on the price, yet the RSI had 2 lower highs. Wait for the trend to break and take your signal to enter short.


Below is an example of bullish divergence with 3 lower lows on the price, yet the RSI had 3 higher lows. Wait for the trend to break and take your signal to enter long.

[MC]

Please post your examples of RSI to help illustrate how you use and interpret this indicator.

Also if further clarification is needed, by all means post questions here so we can answer them for you.

Thanks,
MC

[NoobTrader]

So in the first chart for example the pattern shows the price going up on the 2 higher highs from 156 to 171 on the first red dotted line but right under it on the rsi there are two lower highs (the blue peaks) going lower.

Is that suppose to be a sign that the trend is about to change?, is that the divergence?


I probably don't get this at all but that's why im the noobtrader.

[MC]

Originally Posted by NoobTrader

So in the first chart for example the pattern shows the price going up on the 2 higher highs from 156 to 171 on the first red dotted line but right under it on the rsi there are two lower highs (the blue peaks) going lower.

Is that suppose to be a sign that the trend is about to change?, is that the divergence?


I probably don't get this at all but that's why im the noobtrader.

It's a warning sign called divergence...yep.
Divergence itself means nothing, but it's often a good heads up of a correction or trend change.