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The relative strength index, or RSI, is a momentum oscillator used to measure the speed and magnitude of the directional price movements. The indicator makes it possible to determine the levels of overbought / oversold, as well as providing signals of purchase and sale.
The RSI consists basically of a single line that floats within a corridor that goes from 0 to 100. The closer the line approaches the zero sign, the greater the chances that the asset will enter the oversold zone. When the RSI approaches 100, the asset will probably be overbought. According to the indicator, the price of the asset is bound to be appreciated once the oversold zone is reached and a depreciation occurs when it enters the overbought zone.
How to use the RSI indicator in trading?
As mentioned previously, the RSI ranges between 0 and 100%. Traditionally, RSI is considered to be overbought when it exceeds 70% and oversold when it falls below 30%. If the indicator generates a large number of false signals, it is possible to increase the overbought threshold to 80 and reduce the oversold threshold to 20.
The signals of purchase and sale provided by the RSI
J. Welles Wilder suggested a period of application of 14, which can obviously be modified according to short or long-term strategies. Shorter or longer periods are used for short or long-term forecasts.
The RSI is a universal indicator and can be used for trading on any underlying, from Forex to cryptocurrency or to shares.
It is necessary to remember that during the most robust trends the RSI can remain in the areas of oversold / overbought for prolonged periods.
Setting up and configuring the RSI
To use the RSI, simply follow the following steps:
Optional: adjust the parameters. When you set the indicator, you can adjust the period and levels of overbought and oversold for greater sensitivity / accuracy. Remember that the wider the corridor, the less signals you will receive, but at the same time they will be more precise. The opposite happens when the threshold levels are very close to each other: the crossover signals will appear more often, but the number of false signals will also increase. Remember that if you increase the period setting, you will reduce the sensitivity of the indicator.
Standard approach – 70/30
The standard approach includes a period of 14, the oversold level of 30% and overbought at 70%. These are the most frequently used settings for this indicator. Traders expect the RSI to go beyond the 30 and 70 threshold lines. With standard parameters this will happen quite often, but it will always be a sign of a next trend reversal.
Conservative approach – 80/20
Proponents of the conservative approach suggest a period of 21, the oversold level of 20% and over 80% overbought. Traders wishing to minimize risk set the indicator so that the RSI is less sensitive and therefore generates a minimum number of false signals. Extremely high and low levels – 90 and 10 – occur much more rarely, yet they indicate a particularly strong momentum.
Divergence is another way in which this indicator can be used. If the price movement of the underlying is not confirmed by the RSI, it may indicate a trend shift.
The divergence is the signal of a next inversion of the trend
Divergence can therefore be a good indicator of a forthcoming price reversal. In the example above, the price of the asset falls, while the RSI shows an opposite movement. The situation is followed by a shift in the trend.
RSI is a powerful tool that can help you determine optimal entry and exit points. Sometimes it is able to predict the trend, where other indicators prove to be too slow. However, it is almost never used alone, but must be combined with other indicators (for example, Bollinger Bands or the Alligator).
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Source: IQOption blog 2018-10-08 09:24:43