RSI indicator – A crucial tool for traders to predict price movements

In the trading world, technical analysis is the foundation for many successful traders. The RSI indicator is one of the tools that has established an unwavering position over time. This momentum oscillator helps traders understand when the market may be overbought or oversold. The Relative Strength Index (RSI) is an indicator that analyzes the speed and magnitude of price changes, providing clear signals for decision-making.

The Origin and Revolution of RSI in Technical Markets

RSI was created by legendary technical analyst J. Welles Wilder in 1978. Wilder published his most famous work, “New Concepts in Technical Trading Systems,” in that very year, introducing not only RSI but also other widely used indicators like the Parabolic SAR, Average True Range (ATR), and Average Directional Index (ADX). Before his career shift, Wilder was not naturally a technical analyst—he worked as a mechanical engineer and real estate developer. Around 1972, he began experimenting with stock trading, but his initial results were not particularly successful.

This is a familiar topic for many beginner traders. However, unlike many who might give up on their dreams, Wilder decided to structure his experiences and research. He compiled his trading lessons and scientific analyses into mathematical formulas and indicators. Impressive—his book was completed in just six months. Today, more than 40 years later, many traders and analysts still use methods developed by Wilder.

How RSI Works: Measuring the Market

RSI operates on a clear logic. By default, it calculates price changes over a 14-period observation window—14 days for daily charts, 14 hours for hourly charts. The formula is simple but powerful: it divides the average gain by the average loss and presents the result on a scale from 0 to 100.

From this perspective, RSI is purely a momentum indicator. Momentum reflects how quickly the price is changing. When momentum rises and the price increases, it indicates that buying pressure is dominant in the market. Conversely, when momentum declines, it signals increasing selling pressure. RSI is also known as a “oscillating indicator”—meaning it fluctuates within a set range, providing traders with visual cues about overbought or oversold market conditions.

Numbers are straightforward and consistent. When RSI drops to 30 or below, it suggests that the asset is likely undervalued—market participants are excessively selling. When the score rises above 70, it indicates that the asset is likely overbought—buyers are overly active. However, the standard 14-period setting is not set in stone. Traders can adjust it according to their strategic needs. For example, a 7-day RSI reacts more sensitively to price changes than a 21-day, which smooths out fluctuations and reduces false signals.

Short-term traders often customize the indicator for their needs. For instance, they might set overbought and oversold levels at 20 and 80 instead of 30 and 70 to reduce false signals.

Divergence Strategy: More Precise RSI Application

Beyond the numeric levels (30 and 70), RSI offers other approaches. Many traders analyze divergences, which can indicate trend reversals or support and resistance levels. Here, the concepts of “bullish divergence” and “bearish divergence” come into play.

Bullish divergence occurs when the price and RSI move in opposite directions. RSI scores rise, forming higher lows, while the asset’s price falls, creating lower lows. This suggests that although the price has declined, buying strength is increasing—potentially a sign of an upcoming reversal. Bearish divergence is the opposite: the price makes higher highs, but RSI scores decline, forming lower highs. This indicates that despite the price rising, momentum is waning, and a reversal or correction may be imminent.

However, caution is necessary. During strong market trends, divergences may not be reliable. For example, in a strong downtrend, traders might see many bullish divergences before the actual bottom is reached. Therefore, divergences are better suited for less volatile markets where price movements are more balanced and trends are smaller.

Limitations of RSI and Best Practices

It’s important to understand the limitations of RSI. No technical indicator, including RSI, is 100% effective—especially when used in isolation. False signals are always possible. Therefore, every trader should combine RSI with other indicators and methods.

Choosing trading setups, evaluating RSI scores, and analyzing divergences are all critical factors for effective RSI use. But wisdom and discipline are paramount. RSI is a powerful tool, but only when used correctly and alongside other analytical techniques.