Best indicators to use with RSI

The Relative Strength Index (RSI) is a technical momentum indicator that compares recent price gains to recent price losses. It is primarily used by traders and analysts to indicate possible overbought or oversold conditions in a market. However, overbought and oversold assets do not necessarily turn around immediately. This means that it is beneficial to get confirmation from another trading signal before acting on RSI.

How does the RSI work?

RSI readings range from zero to 100, with readings above 70 usually interpreted as indicating overbought conditions and readings below 30 indicating oversold conditions. Since the RSI measures the magnitude of recent price movements, it tends to generate false signals after sudden, significant price changes.

Generally, if an asset’s price rises, the RSI will also rise because average gains will exceed average losses. When the asset price falls, losses usually exceed gains, causing the indicator to fall.

Moving Average Convergence Divergence (MACD)

One technical indicator that can be used in conjunction with the RSI and helps confirm the validity of RSI indications is another widely used momentum indicator, the moving average convergence divergence (MACD). This indicator calculates momentum differently than the RSI by comparing the relative positions of a short- and long-term moving average.

Traders primarily monitor the MACD for signs of momentum diverging from price. While the price may continue to move up, with the RSI maintaining overbought readings for some time, the MACD is showing divergence by starting to decline as the price continues to advance. This provides an additional indicator that confirms that a market may be reaching a level where it is overextended and therefore likely to bounce back soon.

The MACD and RSI are both contrarian by design. They go against popular opinion by signaling to buy when there is a lot of selling and signaling to sell when there is significant buying. When both indicate buy, the probability is more likely that the security is actually oversold. Likewise, the security is likely overbought and headed lower when both RSI and MACD generate sell signals.

Moving average crossovers

Moving average crossovers can also be used to confirm RSI indications that a market is overbought or oversold. RSI is often used to obtain an early sign of possible trend changes. Therefore, adding exponential moving averages (EMAs) that react more quickly to recent price changes can help.

Relatively short-term moving average crossovers, such as the 5 EMA crossover over the 10 EMA, are best suited to complement RSI. The 5 EMA crossing from above to below the 10 EMA confirms the RSI’s indication of overbought conditions and possible trend reversal. Conversely, an upside crossover provides an additional indication that a market may be oversold.

Iron RSI

It is also possible to apply the EMA process to the RSI itself to obtain the smooth RSI indicator. The smooth RSI is much less jerky than the RSI indicator, resulting in far fewer false positives and better defined trends. On the other hand, smoothing RSI with an EMA also makes RSI slower to respond to true changes because all EMAs add lagged variables.

Long term RSI

Although traders usually use RSI on smaller time scales, it can be used with weeks or even months as inputs instead of days, hours or minutes. By using a longer time scale, it is possible to align short-term trades with long-term trends. If the monthly RSI is still fairly low and rising, a daily RSI buy signal is more likely to succeed.

Likewise, a high and falling monthly RSI indicates that a daily RSI buy sign is likely a false positive. Finally, a daily RSI buy signal could be the start of a new bull market if the monthly RSI is very low and falling.

Livermore’s Pivots

RSI can also be combined with legendary trader Jessie Livermore’s pivot system, which should not be confused with pivots. Much has been written about core points. However, the basic idea is that if a security makes a low and then makes a second lower low, the first low becomes a pivot. If the security’s price rises above that pivot, the downtrend has ended, and it may be time to buy.

What gives many traders trouble with Livermore’s system is figuring out when a downtrend has gone far enough for pivots to work. RSI, with its clean zero to one hundred range, makes this easy. When RSI is below 30 and a bullish reversal pivot occurs, a buy is more likely to produce profit than when either of these signals occurs alone.

As is known, Livermore preferred to play the bear side, so it is possible to reverse the procedure for selling and shorting. When a security makes a high followed by a second higher high, then the first high becomes a bearish reversal pivot. Suppose the security’s price falls below that pivot, and RSI is still above 70. In that case, it is probably time to sell the security and perhaps time to sell it short. Furthermore, Livermore pivots can also be used with smooth RSI for better defined up and down trends.