Relative Strength Index (RSI) is one of the important indicators used in technical analysis. RSI is a momentum oscillator that can be used in stock trading, futures trading, Forex trading and commodity trading. RSI indicator was developed by J Welles Wilder for the commodities market in the late 1970s. But over the years, it has been found to work very well for the Forex as well as the stocks market.
RSI is usually used on the 14 day timeframe and it measures the velocity and magnitude of the directional price movements as a ratio of the higher closes to the lower closes. We don’t need to go into the details of how the RSI indicator values are calculated as you will only need to read the RSI indicator graph values below the price action on the chart. It is called an oscillator as its values oscillate between the two values of 0 and 100.
Overbought and Oversold Indicator
RSI is also known as the Overbought and Oversold Indicator. RSI is plotted on an index of 0-100. 50 is the center line. Readings above 70 are considered to be overbought and readings below 30 are considered to be oversold. However, you will need to confirm this overbought and oversold condition with other indicators!
Divergence Trading Using RSI
Divergences are important trend reversal signals which when combined with other indicators give high probability trade setups. RSI is widely used in identifying divergence patterns. A divergence pattern develops on the chart when the price action moves in one direction and the indicator moves in the other.
For example, the price action is moving up with the slope ascending while on the other hand the RSI is moving down with the slope descending. This pattern is known as a Positive Divergence Pattern or Bullish Divergence Pattern. It indicates a potential trend reversal from up to down. Similarly, when the price action is sloping down while the RSI indicator is sloping up, this indicates the bearish divergence pattern.
Over the years, this RSI indicator has been widely used by the traders to trade Forex, stocks and commodities and it has withheld the test of time. It was introduced in 1978 as said above by Wilder but it still works. That is because this indicator was developed by Wilder using sound theoretical principles that were universal in nature. RSI is extensively used in divergence trading and produces good buy/sell signals!