RSI Relative Strength Index

DEFINITION of RSI Relative Strength Index

RSI Relative Strength Index is a key tool used in technical analysis, assessing the momentum of assets to gauge whether they are in overbought or oversold territory.

WHAT IT IS IN ESSENCE

To calculate RSI:

RSI = 100 – 100/(1+(average up closes/average down closes))

It is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100.

RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings, and centerline crossovers. RSI can also be used to identify the general trend.

J. Welles Wilder is the developer of this tool. He was a technical analyst focused on developing mathematical formulae that would lead to profitable trading systems in highly leveraged securities.

After his partners bought him out of his real estate business in 1972, Wilder turned his attention to the commodities market.

HOW TO USE

There are five major principles of RSI analysis:

1) When RSI goes above 70 or below 30, it indicates that a stock is overbought or oversold and vulnerable to a trend reversal.

2) A reversal often occurs after bullish or bearish divergence. Bearish divergence takes place when the stock breaks out to a new high, while RSI makes a lower high. A bullish divergence occurs when a stock makes a fresh new low, while RSI sets a higher low.

3) An RSI failure swing provides a trading signal. A bearish failure swing occurs when RSI peaks above 70, go below that level, tests the first peak, fails, and breaks support on the RSI chart. The bullish failure swing is the reverse.

4) RSI forms patterns, such as triangles or head and shoulders tops and bottoms. Breakouts from these patterns on the daily chart often precede the price breakout by one or two days — providing the swing trader valuable advance notice.

These four features of RSI often come together to create a high-probability buy or sell signal. Thus, a stock may go over 70, create bearish divergence, form a descending triangle top, and then complete a failure swing. These signals often predict the signal on the price chart.

5) A final use of RSI mentioned in Wilder’s book, New Concepts in Technical Analysis, is that “trendlines on the bar chart often show up as support lines on RSI.”

A corollary of this point, not mentioned by Wilder, is that the RSI line itself can be interpreted by trendline analysis. A break in the RSI trendline can provide a signal that often predicts action on the price chart.