RSI stands for Relative Strength Index, the most used oscillator among retail investors. Most likely, there isn’t a single serious retail investor out there that hasn’t at some point looked at the RSI and ways to use it. As an oscillator, the RSI is projected at the bottom of a chart in a small, separate window and follows the price closely.
Any oscillator calculates its levels based on two things:
- the underlying formula,
- the period considered.
We will not go into the underlying formula the RSI is based on, however, we will discuss the period the oscillator considers.
By default, the RSI uses fourteen periods. This means that the oscillator considers the last fourteen candlesticks before plotting a value corresponding to the current candlestick. Longer periods result in a flatter line for the RSI, and shorter periods cause the RSI to reach overbought and oversold levels more often. In both cases, its interpretation loses relevance. Therefore, the approach when trading with RSI is to make sure the period remains at the default fourteen.
Bullish and Bearish Divergences with the RSI
Investors use divergences with many oscillators. As the RSI is a popular oscillator, we will use it to illustrate this concept.
As the oscillator considers many candles before plotting the current value, investors focus on the oscillator’s moves rather than the price’s. A divergence occurs when the price makes two consecutive highs, while the RSI fails to make the second high. This is called a bearish divergence. If you drag a trendline connecting the two highs on the price chart and the two points on the oscillator’s chart, the two lines diverge. Because investors should follow the oscillator, and that line is descending, it is known as a bearish divergence.
In a bullish divergence, the price makes two consecutive lows, while the RSI doesn’t confirm the second one. The RSI line rises, pointing to higher values. That’s a bullish divergence, and investors tend to go long when it forms.
How to Trade a Bullish or Bearish Divergence with the RSI
We’ll use the USD/JPY daily chart above to illustrate how to trade the bullish divergence that appears on it. Please note, however, that the principle is the same for all timeframes and all currency pairs.
Investors tend to take a long position when the falling trendline in the oscillator window is broken. Usually, by that time the price has jumped and a new low is in place; that low then represents the stop loss or the invalidation level.
As for the take profit, the minimum to target is when the RSI reaches the other extreme (in this case the overbought area). However, the price may still move while in the overbought area, so investors have two options:
- simply buy the entire position as the risk-reward ratio is sufficient; or
- buy half of the position and trail the stop for the remaining half.
- The 14-period is the best to use with the RSI.
- A bullish divergence is when the RSI doesn’t confirm the second of two consecutive market lows.
- A bearish divergence is when the RSI doesn’t confirm the second of two successive highs.
- Aggressive investors book half of the position in the opposite extreme level and trail the stop for the rest.