Developed by Welles Wilder, Jr. is a Momentum oscillator that measures the speed and change of Price movements. Essentially the RSI, when graphed, provides a visual mean to monitor both the current, as well as historical, strength and weakness of a particular market.
The Strength or Weakness is based on closing prices over the duration of a specified trading period creating a reliable metric of Price and Momentum changes. Given the popularity of cash settled instruments (Stock Indexes) and Leveraged Financial products (the entire field of derivatives) ; RSI has proven to be a viable indicator of price movements.
The RSI is a fairly simple formula, but is difficult to explain without pages of examples. Refer to Wilder's book for additional calculation information.
The basic formula is :
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
The default look-back period for RSI is 14, but this can be lowered to increase sensitivity or raised to decrease sensitivity. 10-day RSI is more likely to reach overbought or oversold levels than 20-day RSI. The look-back parameters also depend on a security's volatility. 14-day RSI for internet retailer Amazon (AMZN) is more likely to become overbought or oversold than 14-day RSI for Duke Energy (DUK), a utility.
RSI is considered Overbought when above 70 and Oversold when below 30. These traditional levels can also be adjusted to better fit the security or analytical requirements. Raising overbought to 80 or lowering oversold to 20 will reduce the number of overbought/oversold readings. Short-term traders sometimes use 2-period RSI to look for overbought readings above 80 and oversold readings below 20.
RSI also often forms chart patterns that may not show on the underlying price chart, such as Double tops and bottoms and trend lines. Also, look for Support or Resistance on the RSI.
In an Uptrend or Bull market, the RSI tends to remain in the 40 to 90 range with the 40-50 zone acting as Support.
During a Downtrend or Bear market the RSI tends to stay between the 10 to 60 range with the 50-60 zone acting as Resistance. These ranges will vary depending on the RSI settings and the strength of the security’s or market’s underlying trend.
However being Overbought or Oversold 'does not mean' that the Price will 'not move' further Up or Down the Market needs some time to correct itself. Similarly it also does not mean that you must enter a trade when the market is in either one of the extreme levels.
According to Wilder, Divergences signal a potential reversal point because directional momentum does not confirm price.
- A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum.
- A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.
Bullish signals
During a downtrend, there are two ways RSI signals a potential bullish price reversal upward to the upside.
1. Bullish oversold signal (trend reversal)
A bullish oversold signal occurs when the RSI falls to an oversold level (30% or less), and then rises back above it, generating a signal that bullish sentiment may be gaining momentum.
2. Bullish trend alert (trend confirmation)
A bullish trend alert occurs when the RSI rises from below to above the neutral 50% level. This is more useful when using an RSI time period of 14 days or more than when using less than 14 days.
3. Bullish divergence signal (trend reversal)
A bullish RSI divergence occurs when RSI makes a higher low while price makes a lower low. The more times this occurs the more bullish the signal is believed to be. At times this lack of downside confirmation by RSI can signal that downside momentum is waning. The advantage offered to traders by this type of analysis is that it cannot be seen simply by looking at price action alone.
Bearish signals
During an uptrend, there are two ways RSI signals a potential bearish price reversal upward.
1. Bearish overbought signal (trend reversal)
A bearish overbought signal occurs when the RSI rises to an overbought level (70% or more), and then declines below it, generating a signal that bearish sentiment may be gaining momentum.
2. Bearish trend alert (trend confirmation)
A bearish trend alert occurs when the RSI drops from above to below the neutral 50% level. This is more useful when using an RSI time period of 14 days or more than when using less than 14 days.
3. Bearish divergence signal: trend reversal
A bearish RSI divergence occurs when RSI makes a lower high while price makes a higher high. The more times this occurs the more bearish the signal is believed to be. At times this lack of upside confirmation by RSI can signal that upside momentum is waning. The advantage offered to traders by this type of analysis is that it cannot be seen simply by looking at price action alone.
The Relative Strength Index (RSI) can be useful in a variety of different ways. It can be used to confirm a New trend (with a move from below 50% to above 50%, or vice versa), to suggest when a given move may be getting Overbought (above 70%) or Oversold (below 30%) and also when a potential price reversal may be possible (bullish divergence or bearish divergence).
