InvestorQ : How exactly does RSI work in practice and what is the application of RSI to your trading and charting job?
Arti Chavan made post

How exactly does RSI work in practice and what is the application of RSI to your trading and charting job?

Answer
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1 year ago


RSI is considered overbought when above 70 and oversold when below 30. These traditional levels can also be adjusted if necessary to better fit the security. For example, if a security is repeatedly reaching the overbought level of 70 you may want to adjust this level to 80. Similarly if the lower level of 30 is being breached too often then you can always consider tweaking it to 20. The idea is that the area beyond this range of 30 and 70 should be the outlier range and you should touch that region as an exception and not as a rule. Of course, we have to look at long term breaches and not to short term breaches. That is because, during strong trends the RSI may remain in overbought or oversold for extended periods and that can be taken as a criterion for broadening the range.

The RSI chart can also be analyzed in the same way as the price chart and one can look for formations and patterns in the RSI chart. Typically it has been seen that the RSI also often forms chart patterns that may not show on the underlying price chart, such as double tops and bottoms and trend lines. Also, look for support or resistance on the RSI.

How can the RSI be interpreted in terms of the numerical values. There are some broad empirical rules that we can follow to analyse these numbers. For example, in an uptrend or bull market, the RSI tends to remain in the 40 to 90 range with the 40-50 zones acting as support. On the other hand, during a downtrend or bear market the RSI tends to stay between the 10 to 60 ranges with the 50-60 zones acting as resistance. These ranges will vary depending on the RSI settings and the strength of the security’s or market’s underlying trend. RSI not only covers the direction of the stock movement but also the intensity and the momentum of the price momentum.

How to further interpret the interplay between the chart and the RSI chart? That is perhaps the most important factor from an analytical perspective. Let us consider two distinct cases. If underlying prices make a new high or low that isn't confirmed by the RSI, this divergence can signal a price reversal. If the RSI makes a lower high and then follows with a downside move below a previous low, a Top Swing Failure has occurred. If the RSI makes a higher low and then follows with an upside move above a previous high, a Bottom Swing Failure has occurred. The comparison of the price with the RSI or the juxtaposition of the two charts will help you to identify where these divergences are occurring and position your trade recommendations and your market trades accordingly. Generally, this divergence signal between the RSI and the price chart is considered to be almost an infallible signal.