Understanding the Relative Strength Index (RSI)
The relative strength index (RSI) is a momentum indicator used in technical analysis to measure the speed and magnitude of a security’s recent price changes. Developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, New Concepts in Technical Trading Systems, the RSI offers valuable insights into overvalued or undervalued conditions in a security’s price.
The RSI is displayed as an oscillator ranging from zero to 100. Traditionally, an RSI reading above 70 signals an overbought condition, while a reading below 30 signals an oversold condition. However, the RSI can do more than merely indicate overbought and oversold levels—it can also serve to identify potential trend reversals and price pullbacks.
Key Insights
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Effective Momentum Oscillator: The RSI is a renowned momentum oscillator introduced in 1978 to detect overbought and oversold conditions in asset prices.
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Comprehensive Analysis Tool: It offers signals for bullish and bearish price momentum, complementing other forms of technical analysis.
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Reading Signals for Action: Traders generally see RSI values above 70 as overbought and values below 30 as oversold, using these signals to inform trading decisions.
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Best in Ranged Markets: RSI’s effectiveness is maximized in trading ranges, rather than trending markets.
Mechanism of RSI
The RSI assesses a security’s price performance, comparing gains to losses over a set look-back period, typically 14 days. It incorporates a two-step calculation process:
Calculating the RSI
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Initial RSI Formula:*
RSI_step one = 100 - 100 / (1 + Average Gain / Average Loss)For example, if a market closed higher over 7 out of the past 14 days with an average gain of 1%, and the remaining 7 days closed lower with an average loss of 0.8%, the first RSI calculation is:
RSI = 100 - 100 / 1 + (1%/14) / (0.8%/14) ≈ 55.55 -
Smoothed RSI Calculation
RSI_step two = RSI = 100 - 100 / (1 + (Previous Average Gain × 13 + Current Gain) / (Previous Average Loss × 13 + Current Loss))
Plotting the RSI
After calculations, plot the RSI beneath the asset’s price chart. If the number and size of up days increase, the RSI will rise. Conversely, if down days become more prevalent, the RSI will drop. In any trending market, the RSI helps in anticipating price changes.
Here is an example chart plotting RSI beneath a price chart. Notice how RSI hovers in overbought or oversold regions based on the security’s trend.
Importance of RSI
The RSI can:
- Predict Price Behavior: Vulnerabilities in a security’s price.
- Validate Trends: Act as supplementary indicator with trend lines and moving averages.
- Identify Extremes: Recognize overbought and oversold conditions.
- Create Signals: Generate buy and sell signals for short-term traders.
Using RSI with Trends
Adapting RSI Levels
Understanding a security’s primary trend is crucial for interpreting RSI accurately. For example, an RSI reading of 50 could signify a bearish trend, rather than 70, during downward trends.
Example: In a downtrend, the RSI might often peak near 50 instead of 70, thus helping traders identify bearish conditions accurately.
Implementing Signals
In trending markets, adapt the RSI readings to fit either the bullish or bearish signals. For instance, rely on bullish signals when the trend is bullish and vice versa.
Recognizing Overbought or Oversold Conditions
When RSI crosses 30, it’s considered a bullish sign, and when it crosses 70, it signals bearish conditions. Traders looking to execute trades often use these readings as triggers for buying or selling.
Understanding RSI in Various Ranges
Trend-specific RSI ranges exist during bullish or bearish movements. For instance, in an uptrend, RSI tends to stay above 30, frequently hitting 70. During downtrends, it often touches 30 or lower.
RSI Divergences as Indicators
Positive and Negative Reversals
Positive RSI Reversal occurs when the RSI reaches a lower low but the security’s price achieves a higher low, indicating strengthened bullish momentum. A Negative Reversal implies the opposite.
Example: A bullish divergence is observed when RSI forms higher lows whereas the security forms lower lows, prompting buy signals once RSI breaks out from oversold levels.
RSI Swing Rejections
Bullish swing rejection involves the RSI falling into oversold territory, rising above 30, followed by variation without reentering oversold regions and surging high. Likewise, a bearish swing rejection shows opposite steps.
RSI vs. MACD
Main Differences
The MACD traces the difference between short and long-term moving averages, while the RSI looks at price charge momentum over a recent period. Combining both offers well-rounded technical analysis.
Conclusion
The RSI is invaluable for determining security trends and manageable trading signals through calculated readings. However, optimal use of RSI is contingent on thorough analysis and understanding of its limitations. Its comparison with MACD provides deeper insight into the amplitude and strength of specific indicators. Skilfully adapted, RSI remains an essential part of successful technical trading strategies.
Related Terms: MACD, Bollinger Bands, exponential moving average, trend lines.
References
- J. Welles Wilder Jr. “New Concepts in Technical Trading Systems”, Page 6. Trend Research, 1978.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Page 226. New York Institute of Finance, 2001.
- P. J. Kaufman. “Trading Systems and Methods”, Pages 345-350 John Wiley & Sons, 2019, sixth edition.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Pages 226-227. New York Institute of Finance, 2001.
- Constance M. Brown. “Technical Analysis for the Trading Professional”, Pages 6-9. McGraw Hill Professional, 2011.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Pages 227-229. New York Institute of Finance, 2001.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Page 227. New York Institute of Finance, 2001.
- TradingView. “Relative Strength Index (RSI)”.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Pages 227-228. New York Institute of Finance, 2001.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Pages 237-239. New York Institute of Finance, 2001.
