What is it?
Developed by J. Welles Wilder Jr., RSI was published in his 1978 classic "New Concepts in Technical Trading Systems".
Essentially, RSI is a form of a smoothed momentum
indicator. The term “relative strength” in this case is sometimes
considered as a misnomer as RSI is not used to compare between two
different instruments as the term “relative strength” would normally
indicate. RSI’s formula takes into the consideration of the average
closes of X number of up days and the average closes of X number of down
days to determine a momentum number that ranges between 0 and 100.
Plotted over time, RSI would resemble a line that fluctuations between 0
and 100.
RSI is popularly used to identify potential buy and
sell situations through overbought and oversold situations. It can be
used to spot potential trend reversals through positive and negative
divergences as well as the breaking of its own trendlines.
The first use of RSI is to determine overbought and
oversold levels. Generally, it is considered to be oversold when RSI
dips below 30 and overbought when RSI crosses above 70. However, in
strong trending periods, RSI may stay overbought/oversold for an
extended period of time and as such buy signals are only given when RSI
crosses back above the 30 line from below and sell signals are given
only when RSI crosses below the 70 line from above. It has also been
suggested overbought/oversold signals are more reliable under range
trading than non-trending periods.
| Overbought and Oversold Signals |
Using RSI, we can also gauge the momentum of a
current market direction. When momentums in current market directions
start to fail, positive and negative divergences can be spotted across
the price and RSI levels. Such divergences are also known as "Failure
swings". A bottom failure swing is a bullish indicator of a
possible market bottom, occurs when the price continue to drop to new
lows while RSI does not move in tandem and does not record new lows. A top failure swing
is a bearish indicator of a possible market top, occurs when prices
continue to climb higher to new highs while RSI does not gain in tandem
and fails to record new highs. Wilder considers divergences between RSI
and then price line when RSI is below 30 or above 70 as the single most
indicative characteristic of the RSI and should be considered as a
serious warning whenever spotted.
| Bottome Failure Swing | Top Failure Swing |
Trendlines can also be used in conjunction with the
RSI line. A buy signal is given when RSI breaks above its downward
trendline and a sell signal is given when RSI breaks below its upward
sloping trendline.
| RSI Trendlines |
Conclusion
Depending on your style of trading, whether you are a
momentum trader or range trader, RSI can help you identify better
trading decisions. As with other technical systems, RSI has its
strengths and weaknesses and will perform well in one market environment
and may not do so well in another. Hence understanding when to RSI and
how to use it in conjunction with other technical indicators will most
definitely help us to determine more profitable trades.
Credit: Marcus Fei
