Stock market traders use the relative Strength Index (RSI), a momentum indicator, to evaluate a stock's technical characteristics. 

Traditionally, traders plotted graphs to analyze the stock's market price, which required calculation and knowledge of the traditional formulas. In the modern approach, traders use indicators like RSI to define the market's movement.

1. What is RSI?

J. Welles Wilder created the Relative Strength Index, released in 1978, and gives technical traders a market trading indication.

RSI in stock market analysis is important because it helps spot the technical chart's bullish or bearish price momentum. It is an oscillator that measures the change and speed of a stock's price movement. 

The oscillator varies between 0 to 100. Therefore, the relative strength index is oversold when it is below 30 and considered overbought above 70. You can get an example from the figure below: 

Traders observe the signal of overbought and oversold line crossing and state their decision to buy or sell in the market. Thus, spotting the right RSI is crucial for the entire trading setup. 

RSI reading helps traders make decisions in stock entries through the 0-100 indicator. It works best in the trading ranges of a stock rather than in trending markets. Use it wisely and within trending ranges to get accurate results for trade. 

2. RSI Strategy?

One RSI trading strategy would be to wait for the indicator to suggest an overheated condition during an upswing in trending markets. After that, the trader watches for the RSI to fall below 50, which denotes a long entry. The price will normally rise above this level if the pattern continues and reach new highs.

3. Why RSI is Important? 

The relative strength index meaning is important because of the following points: 

• Traders can use RSI to predict the price behavior of an index or security. 

• It measures the speed in the trading range of the stock. 

• RSI helps to be aware of trend reversals and validate a certain trend. 

• It helps short-term traders to analyze buy and sell signals. 

• It is also helpful for day traders to make wise decisions. 

• RSI points out the overbought and oversold situation for a stock. 

• One of the supportive trading indicators is also used to support other trading strategies.

4. How to use RSI for day trading?

RSI strategy is popular and mostly used by day-traders to benefit through it. However, to understand the use of RSI in day trading, you need to grasp the knowledge of exact RSI setting indicators with trading signals. 

Using the relative strength index in your chart will give you a default setting of 14 periods and 70/30 levels. Using 14 periods refers to using the last 14 bars or 14 candles of the security's price. 

Periods are crucial in RSI as they indicate the security's buying and selling pointers. Using shorter periods can make the RSI reach extreme values (70 or 30) quickly on the chart, whereas using long periods (14 candles) can minimize reaching extreme levels. 

According to the maker of RSI – J. Welles, the right strategy for day trading is recommended as 14 periods of RSI. However, modern financial markets expect different periods per their use in assets, forex, cryptocurrencies, or any other financial market instrument. 

We will help you compare different periods of RSI – 14-day, 5-day, and 5-day settings on the following chart:

In the above comparisons of RSI periods, it is clear that 14-period RSI gives out more than four signals in the beginning. On the other hand, the 5-period shows two signals, whereas the 50-period RSI is stagnant at only one good signal. 

As per Wilder, a 14-period is best because after testing multiple periods, it is the most effective in day-trading and swing trading. Analyzing them through the daily time charts is recommended to predict accuracy. 

5. RSI Overbought or Oversold 

As stated earlier, when RSI crosses 70 on the chart, it indicates bullish movement, whereas when it crosses below 30 there is a bearish sign for the stock. Therefore, under 30 can be estimated as the oversold situation, and above 70 is the overbought situation. 

A trader should keep in check these levels – overbought (70) and oversold (30) to make their buy and sell strategies. The stock may be primed for a strong price pullback or trend reversal. 

4.1 Overbought in stock indicates that the price has reached the maximum of the stock's resistance and is above its intrinsic value. Traders who observe the overbought situation instantly expect a trend reversal or price correction. Therefore, traders are expected to make a short position in the market, keeping other factors in mind. 

4.2 Oversold in the stock is shown by a relative index indicator that shows the price is below the support level of the security. A trader might expect to observe the price movement through the price correction. Interpretation of oversold can help the day-traders to make the right choice at the right time. Usually, traders enter a long position when they observe the market is oversold. 

6. RSI Divergence Indicator Strategy and Examples

The use of divergence in technical analysis signals a major positive or negative price move. Divergence is the direction of the stock which usually diverges or moves from the direction of the price. Usually, the indicator moves in another direction of the price. 

Several other indicators like MACD, RSI, and Stochastic use the Divergence trading strategy. In the case of RSI, when the indicator starts to fall from the overbought position – it is known as bearish divergence. On the other hand, it is known as bullish divergence when the price falls, goes beyond the oversold situation, and rises from the position. 

In the case of RSI, the divergence is shown from either overbought or oversold levels. As you can notice in the chart, the RSI bearish divergence occurs at the end of the uptrend, whereas the bullish divergence occurs at the end of a downtrend. 

For example, RSI divergence occurs when the price moves in the opposite direction of the RSI, and momentum changes during the price change. A bullish divergence occurs with higher and lower levels in the security price. Similarly, a bearish divergence occurs with higher highs and lower highs in the price movement. 

7. Limitations of RSI 

After understanding what is RSI in stock markets, you should know that there are a few limitations to the use of RSI as a technical indicator, which you can find in the list below: 

• RSI helps find bullish and bearish movement signals, although separating them from false indications can be difficult. 

• An indicator displays momentum, which means it can stay either in bullish momentum or bearish momentum for a long time. A trader can confuse the momentum to predict its direction. 

• Trending zones are recommended for RSI, although sometimes false signals are developed during the reversal period, which is critical to predicting. Therefore, it is recommended to analyze RSI with a trading range. 

Bottom Line

Overall, RSI is reliable for traders to analyze the bullish-bearish movement in a stock. It is always important to analyze the stock in a trading range. RSI is used to predict the behavior of the security or an index in the stock markets. The right time period for day trading is 14-period as suggested through traditional aspects. One can define the market's movement using the relative strength index or can support other indicators such as MACD to derive much more accurate results.

Key Takeaways

• RSI is a momentum indicator 

• RSI oscillator varies between 0-100

• RSI when below 30 = Oversold

• RSI when above 70 = Overbought 

• It is a supportive trading indicator that supports other strategies as well.

• A default setting of RSI is 14 days with 70/30 

• A trader should analyze the oversold and overbought situation to make their buy or sell strategy. 

• Divergence is the direction of the stock with positive or negative price movement. 

• When the RSI indicator falls from the overbought position, it is a bearish divergence. 

• When the RSI indicator rises from the oversold position, it is a bullish divergence.