Relative Strength Index
The Relative Strength Index (RSI) is an extremely useful momentum,
oscillating and leading indicator and indicates overbought (price is too
high) and oversold (price is too low) conditions. that was developed by j.welles wilder and is one of the
most widely used indicators in technical analysis that measures current price
strength in relation to previous prices.
This
is a leading indicator of a trend change. The results are used to deliver
messages about the strength of the market. It is used to indicate
when a stock comes off its overbought or oversold conditions. The main purpose of
the study is to measure the market's strength and weakness.
The RSI is a versatile tool,
it can be used to
- Generate buy and
sell signals
- Show overbought and
oversold conditions
- Confirm price
movement
- Warn of potential
price reversals through divergences
The RSI is an oscillating indicator,
fluctuating between 0 and 100. 50 is the centerline. Anything above 70 is considered
overbought, and anything below 30 is considered oversold. While this 70/30
levels are more common.
The RSI is calculated by
monitoring changes in the closing prices of the stock. The number of higher
closes is compared to the number of lower closes for the selected period. The
RSI compares the internal strength of a stock by looking at the average of the
upwards price changes and comparing it with the average of the downward price
changes. The results are expressed as a percentage, providing the upper and
lower boundaries
When the RSI above 70
or below 30 does not indicate a
Top or Bottom. A failure swing or divergence accompanies your
best trading signals.
Another use of the RSI
is divergence. Market prices continue to move higher/lower while the RSI fails
to move higher/lower during the same time period. Divergence may occur in a few
trading intervals, but true divergence usually requires a lengthy time frame,
perhaps as much as 20 to 60 trading intervals.
The
RSI exhibits chart formations as well. Common bar chart formations readily
appear on the RSI study. They are trendlines, pennants, flags, head and shoulders,
double tops and bottoms, and triangles. In addition, the study can highlight
support and resistance zones.
How is it calculated ?
RSI is calculated, using the formula
RSI = 100-100( 1-RS)
Where RS is ( Average Gain) / (Average Loss) for the
specified period. However Average Gain and Average Loss are not true averages
as they are always divided by the period of the RSI, which wilder suggests
should be 14, though some traders prefer using 28 period RSI
Relative Strength &
Divergences
A powerful method for using the Relative
Strength Index is to confirm price moves and forewarn of potential price
reversals through RSI Divergences.
The divergence between RSI Indicator and underlying stock price is
the most important signal provided by RSI, and it can be an indication of an
impending reversal. Using the RSI divergence (bullish and bearish), chart
patterns, trendlines, support, and resistance lines along with the RSI
Indicator chart can be very useful.
Divergence
signals give the trader an advantage by confirming an entry into a downtrend as
it weakens and just before it turns into an up trend. It is also used to get
out of an up trend as it weakens, and before it collapses into a downtrend. The
divergence signal does not occur every time a trend changes, but when it does,
it delivers a strong confirmation signal that a trend break is likely. Traders
use the RSI divergence as an early warning signal to enable them to prepare for
a trend change.
When the RSI and price chart lines move in the
same way we get a confirming signal that the existing price trend is unlikely
to change.
