RSI or Relative Strength Index is one of the most common indicators when charting financial assets. In short the RSI shall give an indication whether an asset is overbought or oversold.
As most indicators RSI is applied on a given timeframe. (e.g. the daily chart of an asset) To get started let`s look an example chart for Bitcoin. On the upper chart you see the price of Bitcoin in form of a weekly candlestick chart.
The purple line below represents the RSI. There are two bands at 70.0 and 30.0. These are the RSI levels that are typically considered as overbought or oversold if the indicator is above or below these bands.
Even though many like to use RSI on their charting, only few really understand what it actually is. So this article should give you a pretty good understanding of what it actually is about and how to work with it!
How is RSI calculated?
I won`t bother you with formulas and such as this is something you can find anywhere on the internet like here on Wikipedia.
So what the Relative Strength Index really does is, it takes a basis price in form of an EMA (Exponential Moving Average – A averaged out price) and sets that in relation to time.
Specifically it takes the prices over a given amount of time, sums that up and gets an average value of that given the number of time points we are looking at. (Typically the indicator is used with a time interval of 15) The shorter the timeframe, the more volatile the indicator.
How to find support and resistance levels with RSI?
To find support and resistance levels using RSI one will have to understand the points above and some common market sense.
So when the indicator moves up, the price increase increases. This kind of indicator is also called oscillator. Same goes vice verse. History has proven that at the top of rallies and drops, the selloff or buying demand increases dramatically and make the indicator top out at 70 (30) or below or above.
As long as the indicator stays within 30-70, by definition this is defined as market moves. It is untypical that on a given time scale the indicator will never touch one of the upper or lower bands.
So to find support and resistance levels using RSI, what you could do is of course looking at territories when the indicator is below or above 30 or 70.
However, it gets much more interesting, when looking at charts that e.g. surpassed 70, corrected below 70 and then made a higher high on the price chart, but only goes up to e.g. 70 on the RSI. This is called a bearish divergence and would indicate a top on the indicator.
To put this example in easy to understand words you can think of it like: “An asset that went up and the RSI follows, corrects, goes up even higher, RSI only goes up a bit.” Now if you understood the “Calculating RSI” part, then this obviously indicates that buying demand (upward momentum) decreased, price increased.
RSI support and resistance levels in bubbles
Typically in bubbles the RSI stays overbought for a longer period of time. (or more likely stays closer or above the 70 line than then 30 line)
What one could do in such a case is adjusting the bands, typically on larger timeframes, in bubbles 90 has been proven as a clear upper band on RSI level.
The RSI indicator is a powerful, yet simple, tool, if you understand what it is about. Of course, I won`t do magic but since it is one of the most common indicators it is important to understand what it really is about.
Please beware that non of the content presented above shall be considered financial advice and is solely for educational purpose only. Previously seen on Hackernoon.
Image Source: Tradingview & Unsplash