RSI indicator for trading: basics and beyond

Stanislav Bernukhov

Senior Trading Specialist at Mt8Pro

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.

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In this guide:

  1. What is the RSI indicator?
  2. Basics behind the RSI indicator
  3. Divergence of relative strength index (RSI)
  4. Confirmation of RSI signals for stocks
  5. Best RSI settings for short-term trading styles
  6. Best RSI settings for long-term trading styles
  7. Pros and cons of using the RSI indicator for stock trading
  8. Looking to trade stocks using the RSI indicator?

In this article, we will talk about the application of the RSI indicator for trading stocks. The relative strength index (RSI) is a popular momentum oscillator used by traders and investors to identify overbought and oversold levels in stocks and other financial instruments. It ranges from 0 to 100 and measures the speed and change of price movements.

Oscillators typically perform well in markets that lock in trading ranges instead of setting long-term trends. This is why using RSI for stocks can be tricky, as stocks often maintain trends for extended periods. Therefore, using RSI blindly, or without other technical indicators for stocks may likely result in losses rather than gains.

This article doesn’t provide any kind of investment or trading advice. Instead, it presents educational material to help you understand the RSI tool better.

What is the RSI indicator?

The relative strength index (RSI), is a widely used momentum oscillator for stock trading technical analysis. It was created by Welles Wilder in June 1978, who detailed its calculation method in his book "New Concepts in Technical Trading Systems". This type of oscillator is a technical analysis tool that measures the speed and amount of price changes in a financial instrument. It compares the average gains and losses of a security over a certain period, helping you determine the asset's strength and weakness.

The RSI calculation is:

RSI = 100 − (100/(1=RS))

You obtain the relative strength (RS) by dividing the average number of up closes over a span of X days by the average number of down closes over the same X-day period. Welles Wilder popularized the use of the 14-day RSI, which is widely adopted. However, you still have the flexibility to choose the number of days for the computation.

Basics behind the RSI indicator

The RSI indicator oscillates between 0 and 100. Generally, an RSI reading above 70 suggests that a stock is overbought. This means it is potentially due for a pullback. On the other hand, an RSI reading below 30 on the price chart suggests that a stock is oversold. This means it is potentially due for a rebound.

This RSI chart shows the price going out of the oversold area.

An RSI indicator reversed to the downside from the oversold conditions area. Source: Tradingview.com

The moment when the RSI crosses a 70 or 20 watermark, you might consider it a trading signal. However, don’t rely solely on such a signal to build your trade.

Using divergence may help you get a clearer picture and a better signal. Divergence is a confirmed signal, meaning it is stronger than a usual RSI signal (when it crosses the oversold area threshold, for example). Divergence, therefore, is more reliable and produces a better hit rate; however, it appears more rarely.

Divergence of relative strength index (RSI)

When you use the relative strength index (RSI) indicator for trading stocks and you notice a divergence between the RSI and the stock's price movements, this might mean great potential for your trades to be successful when bearish divergence or bullish divergence occurs. If the stock you are watching makes higher highs but the RSI makes lower highs, it might indicate a weakening uptrend. On the other hand, if the stock is making lower lows but the RSI is making higher lows, it might suggest a weakening downtrend.

This price chart is an example of an RSI divergence.

Divergence between the price of AAPL stock and RSI indicator. Source: Tradingview.com

Using classic RSI indicator signals for stocks

Let’s take a look at a backtest of a trading system based on the RSI indicator in an application for AAPL (Apple) stock captured from the Trading View community. In this particular case, the strategy is to keep a position open until it generates a signal in the opposite direction.

When you apply the RSI in its simplest form (buy when the RSI escapes the overbought area and sell when it moves away from the oversold area) it produces a similar result across all timeframes — a pretty consistent loss.

Backtest your RSI trading strategies with an automated trading system.

Backtest of an automated trading system based on RSI indicator. Source: Tradingview.com.

That happens due to a very simple fact: most stocks tend to stay within bullish phases for a long time, contrary to currency pairs, which tend to stay in trading ranges.

All oscillators will flash an ‘overbought’ condition in a strong bullish trend, which assumes opening a short position. - Conversely, long positions will be closed relatively early as the market quickly gets into the ‘overbought’ condition, and a trader needs to close the position.

Using divergence for RSI in stocks

You achieve better results when you use bullish divergence or bearish divergence. When the RSI indicator value remains in overbought territory for a long time, you should probably avoid short signals, or apply additional confirmation to them, while favoring long signals.

The dominance of long signals helps you maintain positions in the direction of trends. In the example below, you'll see entry points generated not just in the oversold conditions or overbought areas. That might seem to break the traditional rules, but overbought/oversold prices rarely occur for most stocks. Consequently, the number of positions you trade might end up being very low. That is why sometimes you might accept signals even outside those areas.

An RSI divergence backtest of a trading system.

Backtest of a trading system based on RSI divergence. Source: Tradingview.com

Confirmation of RSI signals for stocks

You can use the RSI indicator as a guide for possible trades, as that is how it is often used, and not as a strict rule for entry. To pinpoint your entry when starting a trade, you can use a confirmation.

For example, a candlestick pattern, such as an ‘engulfing pattern’, could indicate the acceleration of momentum.

Here's how to use a simple engulfing pattern on a candlestick chart within an H1 timeframe to confirm when to enter a trade.

Rather than starting a trade as soon as the RSI gives a signal, you might want to wait for a more dependable pattern to show up and then make your decision to take possible action.

This chart includes the applications of the RSI and candlestick engulfing pattern.

A combination of RSI and a candlestick engulfing pattern trading signals. Source: Tradingview.com

Best RSI settings for short-term trading styles

According to statistics, short-term trading styles usually work best with settings for RSI between 20 and 50. Avoid using parameters lower than 10 as your RSI indicators may become too sensitive, incorrectly signaling overbought or oversold market conditions. However, always test these settings with your specific trading instrument to ensure they're effective.

Best RSI settings for long-term trading styles

As a long-term trader, using a parameter of 50 for RSI can help you avoid overtrading. It's also beneficial to apply this to longer timeframes like daily charts. Remember to define the correct parameter through a backtest. Professional traders rarely change the parameters of their indicators to avoid overfitting.

Pros and cons of using the RSI indicator for stock trading

In this section, we dive into the strengths and weaknesses of using the relative strength index (RSI) for stock trading. On the plus side, this technical analysis tool can help identify good entry points and produce a high win rate while being relatively simple to use. However, it's not perfect: it can often produce false signals, it may not add additional insights beyond price and volume, and its effectiveness can vary across different timeframes.

Advantages of the RSI indicator in stock trading

  1. Stocks often establish long-term bullish trends. The RSI indicator can help to find a good entry point to join such trends.
  2. The RSI indicator is relatively straightforward to use. Basic RSI trading strategies don’t require you to have a high level of trading expertise.
  3. RSI signals don't require a quick reaction from you, as a trader, and usually give you enough time to prepare and execute a trade.
  4. RSI is focused on mean-reversion trading signals, which happen more frequently than trending signals. In other words, if applied correctly, RSI may help you achieve a high winning rate.
  5. Many RSI strategies have already been backtested with results publicly available. These include their application to stocks. Therefore, you don’t need to ‘reinvent the wheel’ or go through a painful process of trial and error when using the RSI indicator.

Disadvantages of the RSI indicator in stock trading

  1. RSI does not work well when it comes to extended trends, and the stock market is known for extended bullish trends. For example, RSI may produce a lot of false counter-trend signals, if applied to an actively growing stock.
  2. RSI is just an indicator, meaning that it is a derivative of the price. If you are a beginner trader, it may help you organize the data, but it can’t add anything specifically new to guide your decision-making other than price combined with volume.
  3. RSI works with mean-reversion signals, which means that it can help a trade to catch the top or bottom of the price action. Mean-reversion strategies are not perfect and may produce losses if the stock price quickly breaks or continues moving in one direction, especially with gaps.
  4. RSI is not very sensitive to price action. It may give you signals too early.
  5. RSI strategies may perform differently across different timeframes, so you must apply in-depth research before using them.

Frequently asked questions

The best strategy suited to using this technical analysis tool for stocks is probably divergence. This RSI trading strategy can enhance your accuracy and timing, letting you spot a change in price action quite early.

Since RSI usually focuses on mean-reversion trades, it makes sense to filter out strong price trends, to avoid being caught on the wrong side of the market. Therefore, RSI pairs well as a leading indicator with moving averages or moving average convergence divergence, which can assist you in identifying trends.

The accuracy of this indicator depends on various factors. Usually, you would use the relative strength index for mean-reversion trades, which typically happen in more than 60% of outcomes. However, you must remember that technical indicators are just tools. Your final performance depends on factors such as proper stop placement, risk, money management, and target setting.

Generally, RSI is designed for operating on short-term to medium-term timeframes, such as hourly charts, 30-minute charts, and four-hour charts. While there are no limitations to the usage of this indicator, a trader should remember that the higher the timeframe, the more ‘trendy’ the market potentially is. RSI indicator works better - at identifying short-term overbought or oversold market conditions, which means operating in a trading range.

Higher timeframes, such as D1,produce less rotation and more momentum.That’s why using a momentum indicator would be preferable for higher timeframes.

On the other hand, trading strategies for RSI built for extremely small timeframes, such as 1-minute or 5-minute charts, are also questionable, as the profit potential for any RSI signals would be too small: traders may end up generating a lot of trading costs with a limited result. So, the best niche for RSI is probably medium-term timeframes between M15 and H4.

The so-called ‘two-period RSI strategy’ was designed for stock trading by Larry Connors . It is a variation of a mean-reversion trading strategy with the second parameter of RSI. The area below 10 is considered a deeply oversold area, and usually, traders can search for buying opportunities under such conditions. Conversely, if the price climbs above 90, traders might search for selling signals.

Like any other mean-reversion strategy, this one is designed not to pick tops and bottoms, but rather to join the dominating trend from the pullback. For following trends, it’s better to use momentum indicators, such as moving averages.

Looking to trade stocks using the RSI indicator?

Remember, no indicator, including the relative strength index (RSI), should be your sole resource for making trading decisions.

You also need to take into account factors like market conditions and how close an asset price is to essential support or resistance levels.

For stocks, it’s important not to maintain a position over the earning report publication’s closed period. Stock prices can fluctuate significantly in the event of an earnings surprise..

Treat the indicator as a guide, not as a ‘holy grail’ predictor of returns. Past performance of any indicator does not guarantee future success.

Ready to start trading stocks and test out the RSI? Open an account with Mt8Pro today.

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.