Relative Strength Index

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Introduction: Relative Strength Index is one of the most extensively used momentum oscillators in the realm of technical analysis of stocks. Developed by J. Welles Wilder, RSI oscillates between zero and 100 and measures the speed and change of price movements. RSI is considered overbought when above 70 and oversold when below 30.

How RSI works: RSI is considered overbought when above 70 and oversold when below 30. These traditional levels can also be adjusted if necessary to better fit the security. For example, if a security is repeatedly reaching the overbought level of 70 you may want to adjust this level to 80. It is very important to understand that during strong trends, the RSI may remain in overbought or oversold for extended periods.

In an uptrend or bull market, the RSI tends to remain in the 40 to 90 range with the 40-50 zone acting as support. During a downtrend or bear market the RSI tends to stay between the 10 to 60 range with the 50-60 zone acting as resistance. These ranges will vary depending on the RSI settings and the strength of the security’s or market’s underlying trend.

If underlying prices make a new high or low that isn’t confirmed by the RSI, this divergence can signal a price reversal. If the RSI makes a lower high and then follows with a downside move below a previous low, a Top Swing Failure has occurred. If the RSI makes a higher low and then follows with an upside move above a previous high, a Bottom Swing Failure has occurred.

Calculation:  The RSI is computed with a two-part calculation that starts with the following formula:

The average gain or loss used in the calculation is the average percentage gain or loss during a look-back period. The formula uses a positive value for the average loss.

To simplify the calculation explanation, RSI has been broken down into its basic components: RS, Average Gain and Average Loss. This RSI calculation is based on 14 periods, which is the default suggested by Wilder in his book.

The very first calculations for average gain and average loss are simple 14-period averages:

  • First Average Gain = Sum of Gains over the past 14 periods / 14.
  • First Average Loss = Sum of Losses over the past 14 periods / 14

The second, and subsequent, calculations are based on the prior averages and the current gain loss:

  • Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
  • Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.

Taking the prior value plus the current value is a smoothing technique similar to that used in calculating an exponential moving average. This also means that RSI values become more accurate as the calculation period extends.

Wilder’s formula normalizes RS and turns it into an oscillator that fluctuates between zero and 100. In fact, a plot of RS looks exactly the same as a plot of RSI. The normalization step makes it easier to identify extremes because RSI is range-bound. When the Average Gain equals zero, RSI is zero. Assuming a 14-period RSI, a zero RSI value means prices moved lower all 14 periods and there were no gains to measure. RSI is 100 when the Average Loss equals zero. This means prices moved higher all 14 periods and there were no losses to measure.

RSI Parameters: The default look-back period for RSI is 14, but this can be lowered to increase sensitivity or raised to decrease sensitivity. 10-day RSI is more likely to reach overbought or oversold levels than 20-day RSI. The look-back parameters also depend on a security’s volatility.

RSI is considered overbought when above 70 and oversold when below 30. These traditional levels can also be adjusted to better fit the security or analytical requirements. Raising overbought to 80 or lowering oversold to 20 will reduce the number of overbought/oversold readings. Short-term traders sometimes use 2-period RSI to look for overbought readings above 80 and oversold readings below 20.

Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range.

Divergence: According to Wilder, divergences signal a potential reversal point because directional momentum does not confirm price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.

Regular divergence can be either positive (bullish) or negative (bearish).

Positive Divergence is bullish and occurs in a down trend when the price action prints lower lows that are not confirmed by the oscillating indicator. This indicates a weakness in the down trend as selling is less urgent or buyers are emerging. When the oscillator fails to confirm the lower lows on the price action, it can either makes higher lows, which is more significant, or it can make double or triple bottoms. The latter occurs more often on oscillators, such as RSI and Stochastics that are range bound and less often on oscillators such as MACD and CCI that are not range bound.

Negative Divergence is bearish occurs in an uptrend when the price action makes higher highs that are not confirmed by the oscillating indicator. This indicates a weakness in the uptrend as buying is less intense and selling or profit taking is increasing. As with positive divergence, the oscillator can fail to confirm the higher highs on the price action by either making lower highs, which is more significant, or by making double or triple tops. As with positive divergence, double and triple tops are more prevalent on range bound oscillators.

Hidden Divergence

Hidden divergence occurs when the oscillator makes a higher high of lower low while the price action does not. This often tends to occur during consolidation or corrections within an existing trend and usually indicates that there is still strength in the prevailing trend and that the trend will resume. In other words, hidden divergence is akin to a continuation pattern. As with regular divergence, hidden divergence can be bullish or bearish.

Bullish Hidden Divergence occurs during a correction in an uptrend when the oscillator makes a higher high while the price action does not as it is in a correction or consolidation phase. This indicates that there is still strength in the uptrend and that the correction is merely profit taking rather than the emergence of strong selling and is thus unlikely to be last long. Thus, the uptrend can be expected to resume.

Bearish Hidden Divergence occurs during a reaction in a down trend when the oscillator makes a lower low while the price action does not as it is in a reaction or consolidation phase. This indicates that the selling has not waned and that that down trend is still strong. The reaction is merely profit taking rather than the emergence of strong buyers and is thus likely to be short lived. As a result, the down trend is more likely to resume in due time.

Key takeaways:

  • The relative strength index (RSI) is a popular momentum oscillator developed in 1978.
  • The RSI provides technical traders with signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset’s price.
  • An asset is usually considered overbought when the RSI is above 70% and oversold when it is below 30%.
  • In finance, the Relative Strength Index (RSI) is a type of momentum indicator that looks at the pace of recent price changes so as to determine whether a stock is ripe for a rally or a selloff.
  • The RSI is used by market statisticians and traders, in addition to other technical indicators as a means of identifying opportunities to enter or exit a position.
  • Generally, when the RSI surpasses the horizontal 30 reference level, it is a bullish sign and when it slides below the horizontal 70 reference level, it is a bearish sign.

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