Relative Strength Index

Advertisement

Introduction

One of the most popular technical indicators used by traders is the Relative Strength Index. The RSI index was first written about by J. Welles Wilder in his 1978 book, New Concepts in Technical Trading Systems. The Relative Strength Index (RSI) is a momentum indicator that that measures the speed and change of price movements measuring the velocity and magnitude of directional price movements.

RSI simply computes momentum as the ratio of higher closes to lower closes. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period.

Calculation

It is calculated using the following formula:

RSI = 100 – 100 / (1 + RS*)

*Where RS = Average of x days' up closes / Average of x days' down closes

Or RS= (Sum of the closing prices of up days/n) / (Sum of closing prices of down days/n)

n = trading periods

Taking the prior period value plus the current period value is a smoothing technique similar to that used in exponential moving average calculation. By using this smoothing technique the RSI values become more accurate as the calculation period get longer.

The RSI is an oscillator that fluctuates between zero and 100. It’s easier to identify extremes using the RSI versus the momentum indicator because RSI is range bound and the Momentum indicator uses absolute values. The RSI is plotted between a range of zero to 100 where 100 is the highest overbought condition and zero is the highest oversold condition. The measuring the strength of a security's recent up moves compared to the strength of its recent down moves we determine whether a security has seen more buying or selling pressure over determined trading period.

The standard RSI calculation uses 14 trading periods which can be adjusted to fit specific trading strategies. Shorter periods will result in a more volatile RSI number and can be used for shorter term trades.

Advertisement

Indicator Interpretations

RSI can be used to identify the general trend and signs weakness in current trend. The RSI is considered overbought when above 70 and oversold when below 30. Other signals generated by indicator divergences, failure swings and centreline crossovers.

Overbought / Oversold

One of the most common uses of the RSI Index is to identify extreme price movements. Once prices enter overbought or oversold zones, traders should consider liquidating positions or reducing current position. By watching extreme levels in the RSI will prevent buying at the top or selling at the bottom. Only when prices confirm a trend reversal should traders consider fading or trading against a prevailing trend. A common mistake novice traders make is to use the RSI Index in isolation and enter into contra trend trades.

 

Centreline Crossover

Centreline crossover can be used to confirm a trend reversals following move out of overbought or oversold zones. Generally readings above the centreline indicate bullish momentum and readings below the centreline indicate bearish momentum. Looking at the Nordic American Tanker (NAT) chart below, we see that the RSI Index was below 30 indicating oversold conditions at the end of January. This suggested that shorts should either exit their or reduce their short positions. In February, we do see the RSI move above the 30 level as downward momentum dries up. This is where novice traders would typically prematurely initiate new long positions. NAT proceeded to trade sideways for the next month most likely whipsawing weak longs in the process. Finally, in March we see the RSI Index cross the centreline confirming the price break above the 24.75 resistance level and the beginning of a trend reversal.

 

Divergence

One of the more reliable techniques when employing RSI indicator is to look for divergence between the direction of the indicator and the direction of prices. Divergences can serve as an early warning that the current trend is about to change. Divergences can be either positive or negative. Positive divergence occur when the RSI indicator advances and the underlying shares decline. Negative divergences occur when the RSI indicator declines and the underlying shares advance. In the Accuride Corporation chart below we see an example how the divergence in the RSI indicator signalled when the 4 month upward trend was about to reverse. The RSI divergence was the first signal that the upward momentum was weakening even though prices formed a consolidation pattern from throughout September.

Failure Swings

In contrast to divergences, Failure swings are independent of price action and based on the RSI indicator alone. A bearish failure swing forms when RSI moves above 70, pulls back, bounces, fails to exceed 70 and then breaks its prior low. It is basically a move to overbought levels and then a lower high below overbought levels. Bullish failure swing forms when RSI moves below 30, bounces above 30, pulls back, holds above 30 and then breaks its prior high. It is basically a move to oversold levels and then a higher low above oversold levels.

ACW is nice example of using Failure swing to initiate a short position at 15.00.

Conclusion

RSI is a versatile momentum indicator that can be used by traders in a number of ways. In simplest use, indicators can stop traders from buying at tops and selling at lows. Momentum indicators can help traders’ time entries to trade in the direction of the trend on pullback opportunities. Positive and negative divergence can help traders see weakening trends that may not appear in price charts. The RSI index can help novice traders take some of the mystery out of why some trends begin or end.