Relative Strength Index

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Introduction of Relative Strength Index

Technicians, technical analysts and traders use indicators on charts to analyze a wide array of securities and to forecast future price movements. And Relative Strength Index (RSI) is one of the most valuable technical indicators whilst trading.

Definition

RSI

The RSI is a technical indicator used in the technical analysis of financial markets. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period. The indicator should not be confused with relative strength.

The RSI is classified as a momentum oscillator, measuring the velocity and magnitude of directional price movements. Momentum is the rate of the rise or fall in price. The RSI computes momentum as the ratio of higher closes to lower closes: stocks which have had more or stronger positive changes have a higher RSI than stocks which have had more or stronger negative changes.

RSI oscillates between zero and 100.

The RSI is most typically used on a 14 day timeframe, as first introduce by J. Welles Wilder, measured on a scale from 0 to 100, with high and low levels marked at 70 and 30, respectively. .... Since then, the 9-day and 25-day Relative Strength Index indicators have also gained popularity.

Shorter or longer timeframes are used for alternately shorter or longer outlooks. More extreme high and low levels—80 and 20, or 90 and 10—occur less frequently but indicate stronger momentum.

History

Wilder

The Relative Strength Index (RSI) was developed by J. Welles Wilder and introduced in his 1978 book, “New Concepts in Technical Trading Systems”, and in Commodities magazine (now Futures magazine) in the June 1978 issue.

The RSI's full name is actually rather unfortunate as it is easily confused with other forms of Relative Strength analysis such as John Murphy's "Relative Strength" charts and IBD's "Relative Strength" rankings. Most other kinds of "Relative Strength" indicators involve using more than one stock in the calculation. Like most true indicators, the RSI only needs one stock to be computed. In order to avoid confusion, many people avoid using the RSI's full name and just call it "the RSI."

Calculation

RSI Calculation



Example 1

RSI - calculation 1



Example 2

You can see from the chart below that the RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued.

RSI-cal2



For those who are more technically minded and want more information in regard to the calculation here is an example….

Example 3

For each trading period an upward change U or downward change D is calculated. Up periods are characterized by the close being higher than the previous close:

calculation example



RSI Trading Signals

Different signals are used in

RSI-bullish/bearish

Chart Formations

The RSI often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart;

Failure Swings ( Support or Resistance penetrations or breakouts)

This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough);

Any readings above 50 (the center line) are considered to be bullish - or at least signify that average gains are higher than average losses - and readings below 50 are said to be bearish, that there are more average losses than gains. Large surges and drops in and asset's price may create false buy or sell signals, so most traders will use RSI only in concert with other tools and indicators.


failure swings

Failure swings also help strengthen other signals.

Support and Resistance levels

The Relative Strength Index shows, sometimes more clearly than price themselves, levels of support and resistance.


support and resistance levels

Divergences

As already mentioned, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index. Prices usually correct and move in the direction of the RSI.

Positive and negative divergences are also thought to indicate future price trends. For example, if the stock's price is falling, but RSI is increasing, some analysts believe this positive divergence signals that the price will soon reverse to mirror RSI. Similarly, if the security's price is rising, but RSI is falling, this negative divergence signals that prices may begin to decline as well.

Take profits on divergences. Unless confirmed by a trend indicator, Relative Strength Index divergences are not strong enough signals to trade in a trending market.

Example

divergences1

Using the corresponding closing prices, insert them into the following formula to get the new up-side price target...

( X - W ) + Y = price target

A down-side price target can be calculated using the negative reversal pattern. Label the peeks and trough on the RSI. Then, using the closing price, calculate the price objective with this formula...

Y - ( W - X ) = price target

Take profits on divergences. Unless confirmed by a trend indicator, Relative Strength Index divergences are not strong enough signals to trade in a trending market.

Trending Markets

Only take signals in the direction of the trend.

Go long, in an up-trend, when RSI falls below 40 and rises back above it.

Go short, in a down-trend, when RSI rises above 60 and falls back below it.

Exit using a trend indicator.

Example

The relative strength index can be used to identify whether a stock is trending or is trading in congestion. By applying moving averages to the RSI and the stock's price, you can determine the likely movement of the stock.

In the following chart, a 9-period simple ”moving average” and a 45-period exponential moving average have been applied to both the price and the RSI of the stock.


trend indicator chart


Use these rules to determine whether the stock is trending or is in congestion...

IF: Price 9-SMA > Price 45-EMA AND RSI 9-SMA > RSI 45-EMA THEN: Trend is up.

IF: Price 9-SMA < Price 45-EMA AND RSI 9-SMA < RSI 45-EMA THEN: Trend is down.

IF: Price 9-SMA > Price 45-EMA AND RSI 9-SMA < RSI 45-EMA THEN: Trend is sideways to up.

IF: Price 9-SMA < Price 45-EMA AND RSI 9-SMA > RSI 45-EMA THEN: Trend is sideways to down.

Note:

A popular method of analyzing the RSI is to look for a divergence in which the security is making a new high, but the RSI is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the Relative Strength Index then turns down and falls below its most recent trough, it is said to have completed a "failure swing". The failure swing is considered a confirmation of the impending reversal.

Using RSI(14)

RSI is a very popular momentum indicator, and the 14 period RSI calculation is one of the most favored weapons that is used for technical analysis. RSI oscillates between zero and 100.

Traditionally, RSI is considered overbought when above 70 and oversold when below 30. Trend is also thought to have turned if RSI moves above or below 50. Additionally, divergences in RSI compared to stock price can often precede significant changes in direction.

Example 1

• One popular way to trade RSI(14) is to go short stocks that are overbought and to go long those oversold. Keep in mind that this indicator defines an overbought stock to have a rating over 70 and is oversold when it is lower than 30.

• The most common way to trade oversold and overbought conditions using RSI(14) is to buy an oversold stock as RSI(14) moves back above 30. Conversely, a short position would be initiated on an overbought stock as RSI(14)drifts below 70.

RSI-overbought/oversold



RSI-overbought/oversold2


• Another successful way to trade RSI(14) is to buy the stock as the indicator moves above 50 or go short as RSI(14) drifts below 50. Since the indicator measures momentum this can be a good tactic to use. A move below 50 RSI(14) often signals a weakening bullish trend or a strong bearish trend.

• Conversely, a move back above 50 signals the end of a bear trend or may indicate a growing bullish trend. Typically, this tactic is used for daily chart analysis.

The final strategy for using RSI(14) is to screen for divergences. A divergence between RSI(14) and price can be a red flag for a major shift in sentiment. Often times when RSI(14) is making news lows, the price of the stock will also be making new lows.

• The same is also true for new highs. Close attention needs to be paid to stocks that are making new lows/highs without new lows/highs from RSI(14).


Example 2
Walmart-RSI


1. Price is trending downwards (staying below the moving average). Do not take long signals until the MA turns upward, otherwise we are trading against the trend.

2. A bullish divergence on Relative Strength Index is reinforced by completion of a failure swing at [2]. Go long [L] when the MA slopes upwards and RSI crosses to above 40.

3. RSI completes a minor failure swing at [3]. Take profits [P] and exit the remaining position [X] when there are two closes below the MA.

Do not go short as price is trending upwards (staying above the moving average).

4. Price has started to fluctuate around the moving average, signaling a ranging market. Go short [S] when RSI crosses from above to below 70.

5. Go long [L] when RSI crosses from below to above 30.

6. There has been a breakout from the trading range and price is trending upwards. Do not close the long position.

7. Take profits [P] on the bearish divergence (Price has completed a higher peak while RSI has experienced a lower peak).

8. Take profits [P]. A bearish triple divergence is confirmed by completion of a large failure swing at [8].

9. Increase your long position [L]. RSI has crossed from below to above 40 during an up-trend.

Exit your position [X] when there are two closes below the MA. Do not go short as the still slopes upwards.

10. A small bearish divergence warns of a possible trend reversal.

11. A bearish triple divergence is reinforced by completion of a failure swing at [11]. Wait until the MA has turned down and RSI has crossed to below 60 before entering a short trade [S].


triple divergence



***Warning***

A trader using RSI should be aware that large surges and drops in the price of an asset will affect the RSI by creating false buy or sell signals. The RSI is best used as a valuable complement to other stock-picking tools.

Conclusion

RSI(14) is one of the most valuable technical indicators for the trader. It can help set up quick moves from overbought or oversold conditions.

Additionally, it can be used to gauge sentiment changes when RSI(14) 50 is crossed over. Most importantly, it can be monitored with price to detect the strength of the trend. When trading, always make sure to be aware if your stock is overbought or oversold and trending in the right direction.

”Success is simple. Do what's right, the right way, at the right time.”





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