If you don't know the Relative Strength Index (RSI), then put simply, it is a technical analysis momentum indicator created by J. Welles Wilder in 1978 and it is employed to calculate the extent of the most recent price changes to assess the conditions of overbought or oversold prices when you trade stocks or other securities. RSI values can be between 0 and 100 and it is applied mainly to determine the turning points and tendencies of the market. This article gives you a basic understanding of the RSI tool and also reveals typical mistakes that can very easily made when using this indicator and how to avoid them.

How RSI is Calculated

RSI is calculated using the following formula: RSI=100−(1+RS100​). RS (Relative Strength) is the average of x days’ up closes to the average of x days’ down closes. The number of periods that are most usually employed in the calculation of RSI is 14. This calculation assists in removing some of the fluctuations in the price of the stock and gives a precise measure of where the stock’s trend is likely to be headed.

Interpreting RSI Values

Traders use RSI indicator to determine when the market is overbought or oversold. As is typical with most oscillators, an RSI value above 70 is usually taken to mean that the stock is overbought and might be due for a correction. On the other hand, if the RSI is below 30 it means that the stock is over-sold and may be due for a bounce up. Nevertheless, these levels are not rigid and should be employed together with other methods of analysis.

Identifying Trends with RSI

Relative Strength Index can be quite really helpful when it comes to determining the direction that the market very likely seems to be going in. Normally when the RSI is above 50, it shows an upward trend while when it is below 50, it shows a downward trend and traders typically search for divergences in which the stock price and the RSI go in the opposite direction as possible signs of trends’ reversals.

Common Problems Encountered in RSI Trading

Traders, however, may make certain errors when applying RSI in their trading despite the fact that it is a very popular tool. These are some of the common mistakes that you can make as a trader and knowing them will help you avoid them and hence protect your trading account.

Overinterpreting

A common mistake is thinking that overbought implies a sell signal and oversold implies a buy signal but unfortunately for all the traders out there, things are never every as simple as they really seem. Although these signals can signal reversal, they are not perfect. However, it is important to note that stocks can stay overbought or oversold for a long time, particularly during the trends. Hence, the other indicators and analysis tools must be employed in order to support RSI signals.

Ignoring Divergence

RSI divergence happens when the price of a stock goes in the opposite direction to the RSI. This is a very useful sign of a potential trend change. Yet, traders do not pay attention to divergence and hence, may miss some trading opportunities. Thus, trading with RSI divergence and other TA tools will help you to improve the efficiency of your trading strategy.

Over-Reliance on RSI Alone

Using RSI alone without the incorporation of other indicators may be devastating to the trader. RSI should be used as one of the tools in the trading system along with other tools like moving averages, support and resistance levels and volume analysis. This approach is more realistic than the previous one as it paints a whole picture of market conditions and possible trades.

Improper Time Frame Selection

It is thus a very common mistake to unfortunately choose the wrong time frame when conducting an RSI analysis and generating signals. For example, if the time period chosen is very short, it might result in a lot of false signals, on the other hand, if the time period is very large, it might not give proper entry and exit points to the trader who is relying on them. It is crucial to select a time frame with which you can comfortably trade and meet your goals. For instance, a day trader could employ shorter intervals of 5-10 days while a long-term investor could prefer longer intervals of 20-30 days.

Guidelines for Trading with RSI

To really maximize the effectiveness of RSI in your trading strategy, consider the following tips:

• Using RSI in combination with other popular indicators like Moving Averages, Bollinger Bands, and MACD will really enhance the outcome of signals and in turn, also really reduce the chances of false signals. It is also good to personalize the RSI period depending on the trading strategy that you prefer and the particular asset you are trading. To find out which settings suit you best, it is a highly recommended strategy to try them out and see how it goes.
• Before applying your RSI strategy to a real account, it would be really wise to first test the strategy using historical data. This lets you determine its efficacy and come up with changes in the rather unfortunate case of a poor outcome. Stop loss will be the method of protecting your capital and position sizing is also a very splendid way of doing so. Something that one should never do is to never stake more than one is very honestly willing to lose.
• One really needs to know the current market news and events that may affect the prices of shares. You can use fundamental analysis together with your technical analysis to get a much better and really clear picture of the market.