Complete Analysis of the RSI Indicator: From Basic Principles to Practical Applications

The RSI indicator is one of the most widely used technical analysis tools in the market and is also the first indicator many investors encounter when learning technical analysis. As a Relative Strength Indicator, it provides an intuitive reflection of the comparison between bullish and bearish forces in the market. Understanding the operating mechanism of RSI, divergence phenomena, and the issue of stagnation is crucial for improving the accuracy of trading decisions.

How Does the Relative Strength Index Measure Market Power?

The core function of the RSI indicator (Relative Strength Index) is to measure the relative relationship between the strength of price increases and decreases of a stock or cryptocurrency over a specific period. Compared to MACD and KD indicators, the calculation method of RSI is relatively simple and intuitive, requiring no complex mathematical knowledge—only basic math operations to understand its principles.

Because of this, RSI is widely applied in stock technical analysis and cryptocurrency trading, often displayed alongside KD, MACD, and other indicators at the bottom of trading interfaces, serving as an important reference for investors to judge buy and sell timing.

RSI Calculation Logic and Example

The RSI formula is: RSI = (Average of recent gains ÷ (Average of recent gains + Average of recent losses)) × 100

This formula compares the strength of upward and downward movements to assess the market’s strength or weakness. Short-term RSI is usually calculated over a 6-day period.

For example, considering a 6-day price change of an asset:

Step 1: Calculate the average of gains = (1+3+2+4) ÷ 4 = 2.5

Step 2: Calculate the average of losses = (2+3) ÷ 2 = 2.5

Step 3: Substitute into the formula = 2.5 ÷ (2.5 + 2.5) × 100 = 50

When gains and losses are roughly equal, RSI approaches 50. If gains are larger than losses, RSI will be above 50; otherwise, below 50. RSI values range from 0 to 100, with 100 indicating a complete uptrend within the period, and 0 indicating a complete downtrend.

How Divergence Indicates Market Reversals?

Divergence in RSI is categorized into two types: top divergence and bottom divergence.

Top divergence occurs when the price reaches a new high over a period, but the RSI only hits a previous high and cannot break through a new high. This suggests weakening upward momentum and potential market correction.

Bottom divergence is the opposite: the price drops to a low, but the RSI low does not make a corresponding new low. This indicates diminishing downward momentum and potential rebound.

Divergence essentially reflects an imbalance in market sentiment. During divergence formation, both bulls and bears are under pressure. When this pressure accumulates sufficiently, market sentiment can suddenly release, triggering a reversal in price movement.

RSI Stagnation Issue and Solutions

A significant limitation of RSI is the overbought stagnation phenomenon.

When the market enters an overbought zone (RSI exceeds 80), a pullback should theoretically occur. However, in strong bullish trends, prices often continue rising while RSI’s upward movement diminishes. As prices keep climbing, RSI slowly ascends, forming a gentle parabolic shape. This is stagnation— the indicator loses sensitivity and cannot accurately reflect market turning points.

To overcome this flaw, investors should not rely solely on RSI for trading decisions but should combine it with other technical indicators for comprehensive analysis.

Five Key Points for Practical RSI Application

1. Divergence is Not a Universal Signal

While divergence has some reference value, it is not always applicable. If RSI frequently crosses the 50 midline during divergence formation, it indicates that prices are fluctuating without significant pressure buildup. In such cases, divergence signals are less reliable.

2. Use the 50 Midline to Judge Market Bias

When RSI breaks above the 50 midline, it indicates bullish dominance; investors should maintain a bullish outlook. Conversely, when RSI falls below 50, it signals stronger bearish momentum, and a bearish strategy should be adopted.

3. Overbought and Oversold Zones as Warnings

RSI exceeding 80 indicates overbought conditions, suggesting a potential short-term correction; RSI below 20 indicates oversold conditions, hinting at a possible rebound. However, these signals should be confirmed with other indicators and not used solely to decide entry or exit points.

4. Multi-Period RSI Coordination Analysis

Many traders set up three RSI lines with periods of 6, 12, and 24 days for comparison. When all three are below the 50 midline and form a “W” shape, it indicates weakening bearish forces and increased likelihood of a rebound. Conversely, when all three are above 50 and form an “M” shape, upward momentum may be insufficient, increasing the risk of decline.

5. Golden Cross and Death Cross Trading Opportunities

When the short-term RSI crosses above the long-term RSI, forming a golden cross, it indicates strong upward momentum and is a good time to buy. When the short-term RSI crosses below the long-term RSI, forming a death cross, it signals a potential sell-off and a good time to reduce positions.

Flexible Adjustment of RSI Parameters

The standard setup usually involves combinations of 6, 12, and 24-day RSI periods. Extending the periods results in smoother RSI movements and slower reactions to market changes, suitable for medium to long-term analysis; shortening periods increases sensitivity, ideal for capturing short-term fluctuations.

Investors can adjust parameters flexibly based on their trading style and market conditions. Before actual trading, it is recommended to practice and test thoroughly using demo accounts to familiarize oneself with RSI’s performance under different market scenarios. This helps in applying RSI more confidently in real trades.

Remember, while RSI is a powerful tool, it has limitations as a short-term technical indicator. The best trading strategy combines RSI with other technical indicators, fundamental analysis, and risk management to form a comprehensive trading system.