Relative Strength Index (RSI)

Relative Strength Index (RSI)

What is the Relative Strength Index?

The relative strength index, or for short, the RSI indicator, was designed by the genius J. Welles Wilder Jr. Wilder, a mechanical engineer who turned into a real estate developer.

He is best known – however - for his work in technical analysis. Wilder is the inventor of several technical indicators that are now considered the pillars of technical analysis software. Wilder features the RSI in his 1978 book, “New Concepts in Technical Trading Systems,” where he talks about the RSI from about page 60 for those interested in reading Wilder’s book. The relative strength index (RSI) is a technical indicator used to analyse financial markets, 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.

Despite being developed over four decades ago, the RSI has stood the test of time and remains one of today’s most popular technical indicators. At its core, the RSI is a momentum oscillator, which, according to Wilder, measures the velocity of directional price movement, shown by way of a value that oscillates between zero and 100.

The basic framework of the indicator consists of an x-axis representing the time scale (Coordinated Universal Time or UTC) and the y axis, which means the magnitude or distance the indicator has moved.

The RSI is not to be confused with the repetitive strain injury syndrome (RSI syndrome).

RSI Reading and and RSI Ranges

We also have notable levels marked at 70.00 and 30.00, as well as 50.00 — more on the uses of these levels in a little bit. The RSI measures momentum as the ratio of higher closes to lower closes, stocks that have had more or bigger positive changes have a higher RSI than stocks that have had more or bigger negative changes.

The RSI is most typically used in a 14-day timeframe. The RSI is presented on a graph above or below the price chart. A reading above 70.00 is considered overbought, and moves below 30 are viewed as oversold conditions.

Think about momentum as the speed of price change. For example, suppose we have a handful of traders buying into a market and price advances. In that case, more traders see this movement and trade consider momentum-based strategies in particular — and before you know it, we have a strong wave of bullish activity (bull market).

These guidelines can help determine trend strength and spot potential reversals. For instance, if the RSI isn't reaching 70 on a number of consecutive price swings during an uptrend but then drops below 30, the trend has weakened and could be reversing to a higher low. The reverse is valid for a downtrend. If the downtrend cannot reach 30 or below and then rallies above 70, that downtrend has weakened and could be reversed to a lower high.

This is where the RSI can be a handy tool to have in your arsenal to help decipher this movement.

Overbought and Oversold Levels

The RSI is most typically used in a 14-day timeframe. A reading above 70.00 is considered overbought, and moves below 30 are viewed as oversold. Since some assets are more volatile and move quicker than others, the values of 80 and 20 are also frequently used overbought and oversold levels. The question most traders ask is how long the market will remain in a state. Are buyers going to run out of fuel or overheat? A price cannot rise continuously. Also, as momentum turns lower and the market selloff, it often tends to over-deliver on the downside.

RSI with recommended parameters and its day-to-day optimisation was tested and compared with other strategies in Marek and Šedivá with randomised testing (e.g. Apple, Exxon Mobil, IBM, Microsoft) and showed that RSI can still produce good results; however, in longer time it is usually overcome by the simple buy-and-hold strategy.

Generally, the RSI is thought of as a leading indicator—a leading indicator essentially provides a buy signal or a sell signal before a new strong trend or reversal occurs. However, some traders refer to the RSI as a coincident indicator, which means it works almost in real-time, providing information about the situation on that particular chart.

Failure Swings and RSI Trendline Breaks

According to Wilder in his book, the RSI failure swings are very strong indications of a market reversal. Right so, failure swings are independent of price action, focusing solely on RSI for signals and ignoring the concept of divergences.

A bullish failure swing forms when RSI moves below 30 (oversold), bounces above 30, pulls back, holds above 30, and then breaks its prior high. It is a move to oversold levels and then a new high above oversold levels.

During a bear market, a bearish failure swing, or top, forms when RSI moves above 70, pulls back, bounces from a low but fails to exceed 70, and then breaks its prior low. Think of these formations as the potential beginnings of a trend which from before price action. "Failure swings" above 50 and below 50 on the RSI are strong indications of market reversals. For example, assume the RSI hits 76, a pullback to 72, then rises to 77. If it falls below 72, Wilder would consider this a "failure swing" above 70.

Finally, Wilder wrote that chart formations and areas of support and resistance could sometimes be more easily seen on the RSI chart than the price chart. The centerline for the relative strength index is 50, which is often seen as both the support and resistance line for the indicator.

Two period divergence

Apply a short five period RSI (RSI 5) over the longer (default) 14 period RSI (RSI 14) and watch for crossovers. With the RSI 14, there are times when the market does not reach the oversold or overbought levels before a shifting direction occurs. A shorter period of RSI is more reactive to recent price changes, showing early signs of reversals. When the RSI 5 crosses above the RSI 14, it means that recent prices are getting higher.

When the RSI 5 crosses above the RSI 14, it means that recent prices are getting higher. A buy signal is generated, and a 5 vs. 14 crosses should happen when the 5 periods (blue) are oversold (below 30). When the RSI 5 crosses below and becomes lower than the RSI 14, it means that recent prices are declining

Price Oscillator Divergence
and RSI and MACD

Wilder actually stated in his book that the rsi divergence signal is the most indicative characteristic of the RSI. So, divergence is formed when price movement and the RSI indicator diverge — move in opposite directions if you will — which can provide a healthy cue of a market turning point.

Like RSI, moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The result of that calculation is the MACD line. A nine-day EMA of the MACD called the "signal line" is then plotted on top of the MACD line, which can trigger buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell or short the security when the MACD crosses below the signal line.

The RSI, however, does a reasonably good job in telling traders when that trend or decisive movement is slowing through the centreline cross, as well as overbought and oversold signals and divergence moves. This lessening of momentum, of course, can be difficult to decipher on a naked chart (so no indicators), especially for newer traders. However, it is critical to note that less momentum, as measured by the RSI, does not always translate to a reversal, but it does signal something is changing. This could mean the market’s action is taking a breather, so consolidating before the next leg up in an uptrend. To help solidify our understanding, a good idea would be to show common divergences drawn from first and then underline the practice on a couple of charts.

There are four common divergences newer traders must be aware of bullish and bearish regular or normal divergences and then hidden bullish or bearish divergences. Divergence takes shape when the RSI forms a higher low that matches correspondingly lower lows in the price. A bearish divergence occurs when the RSI creates an overbought reading followed by a lower high that matches corresponding higher highs on the price.

RSI Calculation Formula

For hidden bullish divergence—see the lower parts of the diagram—we can see that price makes a higher low, yet the RSI generates a lower low. Conversely, a bearish hidden divergence signal consists of a lower high in price and a corresponding higher high from the RSI. For hidden divergences, I have mostly seen these forms as continuation signals within a trend.

The RSI indicator is divergence signals to form within or very near overbought and oversold territory. However, especially with the hidden divergences, sometimes this is just not possible. So, really, what regular divergence is showing us is when momentum is losing and could form a price reversal.

Hidden divergence essentially occurs when the trend holds up despite the momentum going against it shown by way of the RSI. This echoes strength in price and offers a continuation signal within the prevailing trend. Despite the growing bearish momentum implied by the RSI for hidden bullish divergence, for example, the trend structure held up and showed hidden strength to the upside. Hence, the hidden divergence represents a window for joining the bull trend at the bargain. So, it is important to keep in mind that regular divergences are possible signals for trend reversals while hidden divergences signal trend continuation.

And finally, let’s check out RSI failure swings, which, according to Wilder in his book, are very strong indications of a market reversal. Right so, failure swings are independent of price action, focusing solely on RSI for signals and ignoring the concept of divergences.

Next up, we have the EUR/USD daily chart showing regular bullish and bearish divergences. I hope this chart is clear for everyone. One of the attendees in my previous webinar asked if I could fill the slides with the charts I use to make them easier to see.

The mathematics behind the RSI indicator. 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 (higher high). Conversely, a down period is characterized by the close is lower than the previous period's close (lower low).

Both U and D are zero If the last close is the same as the previous. The average U and D are calculated using an n-period smoothed or modified moving average (SMMA or MMA), which is an exponentially smoothed Moving Average with α = 1/period. Some commercial packages, like AIQ, use a standard exponential moving average (EMA) as the average instead of Wilder's SMMA. Wilder originally formulated the calculation of the moving average as: newval = (prevval * (period - 1) + newdata) / period. This is fully equivalent to the aforementioned exponential smoothing.

New data is simply divided by period which is equal to the alpha calculated value of 1/period. Previous average values are modified by (period -1)/period, which in effect is period/period - 1/period and finally 1 - 1/period, which is 1 - alpha. The ratio of these averages is the relative strength or relative strength factor. If the average of D values is zero, then according to the equation, the RS value will approach infinity so that the resulting RSI, as computed below, will approach 100.

The relative strength factor is then converted to a relative strength index between 0 and 100. The smoothed moving averages should be appropriately initialised with a simple moving average using the first n values in the price series. Here’s the rather grim-looking formula, which is essentially 100 minus 100 divided by 1 + the RS. RSI = 100 – 100 / (1 + RS).

Defining a trend with the RSI

Two ways to help define a trend. The first is a bullish or bearish 50.00 centreline cross, and the second uses bullish or bearish failure swings. A rising centreline crossover means the RSI value crosses above the 50 lines, in the direction of the 70.00 thresholds and indicates the trend is increasing in strength: a bullish signal until the RSI approaches the 70 overbought conditions line. This, if you think about it. Informs us the average gain is larger than the average loss.

On the other hand, a falling centerline crossover takes shape when the RSI value falls below the 50-centreline line, in the direction of the 30 line, which indicates the trend is weakening and is seen as a bearish signal until the RSI approaches the 30 oversold line. This, of course, informs us that the average loss is greater than the average gain, that is all there is to it for the bullish and bearish centreline cross. Quite simply then, when the RSI value climbs above the 70.00 mark, this is considered an overbought environment. Conversely, movement beneath 30.00 is oversold.

Look, so, Wilder, in his book, actually refers to overbought and oversold as just tops and bottoms. However, I’ve also seen this movement referred to as also overvalued and undervalued. We can see overbought and oversold as warning signs. So, an RSI value within overbought tells me that long-positions might not be the best move at that moment.

A key point to note is the RSI tends to top and bottom out prior to price action, providing an indication that a reversal could be on the cards, or at least a reaction. And these tops and bottoms form within overbought and oversold areas. Think of these areas as zones where buyers and sellers show exhaustion is sometimes seen. Or when upside momentum or downside momentum dries up.

Another key point to be aware of when looking at overbought signals and oversold signals is that although, yes, we do have an oversold signal when the price crosses into 30 and an overbought signal when we cross into 70, but this can be difficult to use in trading as if the market is in a trending environment or begins to trend out of a range, the RSI can remain in overbought and oversold space for a prolonged period, potentially causing a number of false trading signals.

As many short-term traders will be looking to short a market when the RSI value is in overbought for example, and if it remains within the area, this could be problematic if the value.

Well, some traders look for the RSI value to actually form a peak or bottom and exit the overbought and oversold conditions. This can then be looked upon as a bearish divergence or bullish divergence.

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