RSI Trading Strategy: RSI Calculation & Overbought and Oversold Levels

Intro

Introduced by J. Welles in 1978, the Relative Strength Index (RSI) indicator has gained popularity among traders by helping them overcome challenging market conditions. In the new era of crypto markets, RSI has solidified its usability by transcending the inherent volatility of this market.

We will explore the core concepts of RSI, like overbought and oversold levels, trying to understand the formula behind it and how it can integrate strategically with other indicator tools.

What is the RSI: Diving Deep into the Relative Strength Index

The RSI is a technical tool that has made its place in the financial markets, and most recently in the crypto market, as a versatile indicator standing out by offering a quantitative approach alongside simplicity, making it able to adapt to different market conditions and still produce reliable signals.

The Relative Strength Index belongs to the category of momentum oscillators. The use of this indicator is to identify overbought or oversold levels and address rapid changes in the price action of an asset.

That characteristic makes it suitable for overcoming the inherent volatility of the crypto market. The RSI line oscillation can follow rapid price changes and produce signals on:

• Reversal points.
• Divergence.
• Trend continuation.
• Weakening momentum.

Trading Strategy: Integrating RSI into Your Overall Approach

The versatile character of the RSI makes it an indicator capable of integrating with other technical tools like moving averages, Bollinger bands, MACD, and the stochastic oscillator, which has its version of Stochastic RSI.

For an advanced comprehension using RSI with other price concepts and technical tools, let's classify them into charting tools and oscillators.

RSI with Charting tools

For this group, let's aggregate price action concepts along technical indicators. In price action concepts, we will discuss support and resistance, candlestick formations, and chart patterns.

• RSI with support and resistance: The RSI line moving above the 70 value, detecting an overbought zone at the time that is coinciding with a price resistance level, is a signal of a reversal point and a sell opportunity for a potential downtrend. In the case of support levels, an RSI moving below 30 in an oversold zone indicates the price could bounce off the support level and be a potential buy entry.
• RSI and candlestick formation: Similar to the support and resistance case, values above 70 in the RSI while a bearish candlestick pattern is forming strengthen the scenario for a potential reversal. Otherwise, values below 30 in the RSI alongside a bullish candlestick pattern add a layer of confirmation for an uptrend.
• RSI in combination with chart patterns: In this case, chart patterns like a Double Top can generate a divergence when the price makes a new high, but the RSI line does not. Such a scenario showcases a weakening momentum in the price action and an opportunity for a short position.
• Divergences and RSI: Divergence is an idea traders can detect across various scenarios. In the case of RSI, a divergence occurs when the price makes a new high or low swing, but the oscillator does not move along with the price and instead for the contrary side. Divergence can happen in trends, support/resistance levels, and chart patterns.
• Moving averages with RSI: Moving averages are chart line indicators that help identify the underlying trend in an asset. Using MA with RSI will confirm uptrends and downtrends. An RSI that oscillates above 50, along with a rising moving average, confirms an upward trend. Below 50, while the moving averages are falling, the downtrend is confirming.
• Bollinger Bands and RSI: Bollinger Bands is a chart tool that gauges volatility and detects breakout momentums. The RSI and Bollinger Bands make a strong filter for overcoming volatile conditions. In the case of volatility, when the Bollinger Bands contract noticeably and then the price breaks out, the role of RSI is to measure the potential direction according to its oscillator if it is above or below 50, indicating increased buying or selling pressure.

RSI with Oscillators

For the case of oscillator indicators, let's discuss the integration of RSI with the Moving Average Convergence Divergence (MACD), Stochastic Oscillator, and Commodity Channel Index (CCI).

• Stochastic and RSI: Since both indicators measure overbought and oversold momentum, using the RSI with Stochastic will offer reliable confirmation for divergence signals and trend strength. For example, the RSI is pursuing a new high in price, oscillating above the 50 value. Stochastic is also oscillating upward, aiming for its overbought value of 80 without reaching it yet, making this scenario a confirmation for uptrend signals.
• RSI with MACD: MACD is an oscillator that follows trends, while RSI identifies momentum. Both combined are a powerful tool for measuring market strength during trends and spotting divergences for reversal points. For example, the price is moving toward higher highs, but the RSI is making lower highs, and the MACD is crossing lines, denoting a weakening momentum. The trader is now detecting a divergence for a bearish position.
• CCI and RSI: The Commodity Channel Index measures price deviations and, in combination with RSI, identifies trend reversals based on deviation from zero by the overbought or oversold levels highlighted in the Relative Strength Index. For example, the price is over a resistance level while the RSI is above 70, indicating an overbought level, and the CCI is breaking its overbought threshold above +100. This scenario is a perfect confirmation signal of a price correction for a downtrend.

The formula: Deciphering How RSI Calculates Market Momentum

The Relative is not just a line oscillating between two values. Behind, there is a mathematical calculation based on a formula that assesses recent price movements.

But what is calculating RSI? Let's breakdown it:

1. Average Gain: This calculation represents the average price increase over an exact period, typically 14 days, but fixable to the needs of traders.
2. Average Loss: Conversely to average gain, this calculation represents the average price decrease in the same period.
3. Relative Strength (RS): The Relative Strength derives from dividing the average loss by the average gain. An upward momentum results from a higher RS, and a lower RS indicates a downward momentum.

Those calculations then formulate values between 0 and 100 using the RS like this:

RSI = 100 - (100 / (1+ RS))

Overbought and Oversold: Understanding Market Conditions

When the price has risen rapidly, pushing the RSI value over 70 and above, which means an overbought level, the market could be ready for a correction.

On the contrary, when the price has fallen rapidly, pushing the RSI value below 30, which means an oversold level, the market could be ready for a rebound.

Conclusion and call to action

The Relative Strength Index is such a versatile indicator that it can integrate with other significant tools, boosting its reliance. The simplicity of this indicator makes it a popular choice for beginners and advanced traders.

The effectiveness of this indicator relies on its mathematical approach to calculate the price movements. However, we must remember that RSI is an indicator tool, not a prediction crystal ball. We encourage you to use it considering risk management concepts and test it on paper trading accounts like the ones offered by Altrady.com.