RSI - Relative Strength Index
The relative strength index (RSI) is one of the most popular and well known momentum indicators used for technical analysis. It is used to signal overbought and oversold conditions in a security.
Relative Strength Index Technical Analysis
The relative strength index indicator is plotted between a range of zero to 100 where 100 is the highest overbought condition and zero is the highest oversold condition. The RSI helps to measure the strength of a security's recent up moves compared to the strength of its recent down moves. This helps to indicate whether a security has seen more buying or selling pressure over the trading period.
Like most indicators used for technical analysis, there are two general ways in which the relative strength index indicator is used to generate signals - crossovers and divergence. In the case of the RSI, the indicator uses crossovers of its overbought, oversold and centerline.
RSI Crossovers (Overbought/Oversold) and Technical Analysis
While opinions vary, the RSI overbought and oversold levels are generally 70 and 30. Using these levels, traders use Relative Strength Index and to generate buy and sell action signals through technical analysis. Typically, a security is considered overbought when the RSI is above 70. When the RSI indicator is below 30, traders generally see this as the security being oversold. These values can be adjusted to your particular trading method to increase or decrease the amount of signals that are generated by the Relative Strength Index. If you set the levels to 80-20, you will get fewer signals, but possibly more accurate, and if you set the levels at 60-40, you will get more signals, but possibly less accurate. You should experiment to find what works best for your trading method.
If the RSI is below 30, and then moves up and crosses over the oversold line, this is considered a buy signal to take a long position or to close a short position. Generally this indicates that the security has reversed its prior trend as Bears start taking profits and Bulls start buying expecting the market price to correct itself and move back into the normal range. As for the reverse, if the RSI is above 70, and then moves down and crosses below the overbought line, this indicates a sell signal to take a short position or to close a long position.
As you can see in the above graph, here were two very clear signals that had great trades. Even though the buy signal only marginally dipped into the oversold area, technical analysis of the RSI indicates the price was lower than normal and oversold at the end of the down trend. As the investors started reversing their positions, the price started going back up. When the Relative Strength Index crossed up over the 30 line, anybody in the trade going long would have realized great profits as the trend climbed.
As the trend hit its peak, the RSI had moved over the 70 line, and investors once again started reversing their positions. As the Relative Strength Index line crossed back below 70, indicating a sell signal, there were again great profits to be made by selling short.
Another crossover technique used in generating action signals is using the centerline (50). This technique is exactly the same as using the overbought and oversold lines to generate signals. This technique will often form signals after a movement in the direction they are predicting but are used more as a confirmation then a signal compared to the other techniques. A downward trend is confirmed when the Relative Strength Index crosses from above 50 to below 50. An upward trend is confirmed when the RSI crosses above 50. This can be used completely separate from the 30-70 lines, but is often more powerful and accurate when the two methods are used together.
RSI Divergence and Technical Analysis
Using proper technical analysis, divergence can be used to form signals as well. If the RSI is moving in an upward direction and the security is moving in a downward direction it signals to technical traders that buying pressure is increasing and the downtrend may be coming to an end. For example, consider a security whose price is falling, but the Relative Strength Index rises from a low point (for example 15) back up to 55 or more. Because of how RSI is calculated, the underlying security will often reverse its direction soon after such a divergence occurs. Divergence can also be used to signal a reversal in an uptrend where the RSI is decreasing, which signals increasing selling pressure in an upward trend. Divergences that occur after an overbought or oversold condition are especially reliable.
Relative Strength Index Calculation
RSI = 100 - (100 / ( 1 + RS))
RS = AG / AL
AG = Average Gain = [(previous AG * 13) + current Gain] / 14
First AG = Total of Gains during prior 14 periods / 14
AL = Average Loss = [(previous AL * 13) + current Loss] / 14
First AL = Total of Losses during prior 14 periods / 14
(losses calculated as positive values)
RSI is a running or moving calculation. the accuracy depends upon how long ago the calculations started. The first RSI value is an estimate, and each data point past that improves the estimate. The longer the calculation runs, the more accurate the technical analysis of the RSI will be. You should calculate at least the same number of periods prior to the start as your period for the calculation. For example, if your RSI period is 14, then you want to start calculating at least 14 periods before the first RSI calculation you want to use.
When the average gain is greater than the average loss, the Relative Strength Index value increases because RS will be greater than 1. When the average loss is greater than the average gain, the RSI decreases because RS will be less than 1. If the average loss ever becomes zero, RSI becomes 100 by default, not that you will be likely to see that. The more data points you use to calculate the RSI, the more accurate the results for technical analysis.
The standard calculation uses 14 trading periods as the basis for the calculation. This should be modified to fit your trading method. Using a shorter period will cause the RSI indicator to be more volitile, and therefore should be used for shorter term trades. Using a longer period will cause the RSI indicator to be less volitile, and therefore should be used for longer term trades.
Fortunately, most charting software has a built in RSI indicator, so its just a matter of selecting your desired parameters and watching the display giving you fairly accurate results so you can concentrate on technical analysis.
Relative Strength Index Summary
The RSI is a standard component on any basic technical chart. The Relative Strength Index focuses on the momentum underlying the security and is a great indicator used for technical analysis. It is important to note that the RSI is often not used as the sole generation of buy and sell signals but used in conjunction with other indicators and chart patterns. This relatively simple indicator can quickly be incorporated into any trading strategy. As with any indicator, always experiment with it to find the best match for your trading method.
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