RSI stands for Relative Strength Index, and it is a technical analysis indicator that measures the strength of a security or asset by comparing its recent gains to its recent losses. It was developed by J. Welles Wilder in 1978.
The RSI indicator is usually displayed as an oscillator, which means it fluctuates between 0 and 100. When the RSI is above 70, it is considered overbought, which means that the price may have risen too much too quickly and could be due for a correction. When the RSI is below 30, it is considered oversold, which means that the price may have fallen too much too quickly and could be due for a rebound.
How to use RSI indicator
To use the RSI indicator, traders usually look for divergences between the RSI and the price action. For example, if the price of a stock is making higher highs, but the RSI is making lower highs, this could be a bearish divergence, which could indicate that the stock is losing momentum and may be due for a reversal.
Traders also use the RSI indicator to identify potential entry and exit points. For example, if the RSI is oversold and then crosses above the 30 level, this could be a signal to buy. Similarly, if the RSI is overbought and then crosses below the 70 level, this could be a signal to sell.
Divergences as a key
Divergences are often used by traders to identify potential trend reversals or continuation patterns. Divergences occur when the price of a security or asset and an indicator used to analyze it, such as the Relative Strength Index (RSI), move in opposite directions.
There are two types of divergences: bullish and bearish. Bullish divergences occur when the price of an asset makes a lower low, but the indicator makes a higher low. This could indicate that selling pressure is weakening, and buyers may soon take control, potentially leading to a price reversal to the upside. Conversely, bearish divergences occur when the price of an asset makes a higher high, but the indicator makes a lower high. This could indicate that buying pressure is weakening, and sellers may soon take control, potentially leading to a price reversal to the downside.
Traders use divergences in conjunction with other technical analysis tools to confirm potential trading opportunities. For example, if a trader sees a bearish divergence on a chart, they may look for other signs of weakness in the market, such as a break below a key support level or a bearish candlestick pattern, to confirm their bearish bias and potentially enter a short position.
It’s important to note that divergences are not always reliable signals and should be used in conjunction with other technical analysis tools to confirm potential trading opportunity.