RSI-Relative Strength Index

RSI-Relative Strength Index

The Relative Strength Index (RSI) was created by J. Welles Wilder Jr. and introduced in his book, “New Concepts in Technical Trading Systems,” published in 1978. Wilder was a mechanical engineer and real estate investor before going into market research and trading. He spent most of his life in Greensboro, N.C., before moving to New Zealand.

RSI is one of several popular technical indicators developed by Wilder, including Parabolic SAR, Average True Range (ATR) and the Average Directional Movement Index (ADX). Still widely used, these classic indicators are often included by default in charting and technical analysis software.

Details of Relative Strength Index (RSI)?

The RSI moves higher when the average gains over a period, typically 14 days, are larger than the average losses. The indicator moves down when the averages losses are greater than average gains. Put another way, if the indicator is at 100, over the last 14 days it was all gains. If the indicator is at zero, all 14 periods were losses.

Formula

The indicator is calculated using the following formula, which requires a number of steps:
*RSI = 100 – [100/(1+RS)]
*Where RS = Smoothed Average Gain / Smoothed Average Loss
*Average Gain = Sum of gains over the last 14 periods/14
*Average Loss (expressed as a positive number) = Sum of losses over the last 14 periods/14
To create a smoothed RSI average, similar to a moving average, another step is added:
*Smoothed Average Gain = [(previous Average Gain) x 13 + current Gain]
*Smoothed Average Loss = [(previous Average Loss) x 13 + current Loss]
The indicator is typically used on daily charts with a period of 14, which equates to 14 days. Decrease the number of periods to make the indicator more sensitive to price changes. Increase the periods to make the indicator less sensitive.
Using the indicator on other timeframes also works. A 14-period RSI applied to an hourly chart will base calculations off the last 14 hours.

RSI as a Technical Analysis Tools

The Relative Strength Index (RSI) is one of the more popular technical analysis tools; it is an oscillator that measures current price strength in relation to previous prices. The RSI can be a versatile tool, it might be used to:

  • Warn of potential price reversals through divergences
  • Generate potential buy and sell signals
  • Confirm price movement
  • Show overbought and oversold conditions

Buy and sale signal

The chart above of eBay shows some potential buy and sell signals.

RSI Potential Buy Signal

A trader can be buy when the RSI crosses above the oversold line (30).

RSI Potential Sell Signal

RSI

This is a best idea to sell when the RSI crosses below the overbought line (70).Varying the time period of the Relative Strength Index might increase or decrease the number of buy and sell signals. In the chart below of Gold, two RSI time periods are shown, 14-day (default) and 5-day. Notice how in this example, decreasing the time period made the RSI more volatile, increasing the number of buy and sell signals substantially.

There is another way a trader might interpret Relative Strength Index buy and sell signals. This, and how to interpret RSI divergences, is all contained on below.

RSI Divergences

50 crosed

An alternative way that the Relative Strength Index (RSI) may give buy and sell signals is given below:

  • A trader might buy when price and the Relative Strength Index are both rising and the RSI crosses above the 50 Line.
  • Similarly, a trader might sell when the price and the RSI are both falling and the RSI crosses below the 50 Line.

An example of this potential methodology for buying and selling based on 50 Line crosses is given above in the chart of Wal-Mart (WMT):

Relative Strength Index Confirmations & Divergences

Another usage for the Relative Strength Index is to attempt to confirm price moves and attempt to forewarn of potential price reversals through RSI Divergences.

The chart below of the E-mini Nasdaq 100 Futures contract shows the RSI confirming price action and warning of future price reversals:

Price Action

Low #1 to Low #2

The E-mini Nasdaq 100 Futures contract’s price made a substantial move from Low #1 to Low #2. The RSI confirmed this move, which may have helped a trader have confidence jumping on board the price move higher.

The break of trendline of the e-mini future was also confirmed by the trendline break of the Relative Strength Index, suggesting that the price move may likely be over.

Low #3 to Low #4

A bullish divergence was registered between Low #3 and Low #4. The e-mini Nasdaq 100 future made lower lows, but the RSI failed to confirm this price move, only making equal lows. A trader might see this RSI divergence and begin taking profits from their shortsells.

High #1 to High #2

A bearish divergence occured when the e-mini futures contract made a higher high and the RSI made a lower high. This bearish divergence suggested that prices could be reversing trend shortly. A trader might consider reducing their long position, or even completely selling out of their long position.

Download Three exponential moving averages with MACD and RSI

Risk warning:

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