What is the Relative Strength Index (RSI)?
The Relative Strength Index (RSI) is one of the most popular and widely used momentum oscillators. It was originally developed by the famed mechanical engineer turned technical analyst, J. Welles Wilder. The RSI measures both the speed and rate of change in price movements within the market.
The value of the RSI oscillator, typically measured over a 14-day period, fluctuates between zero and 100. In general, the index is deemed to indicate oversold market conditions when below 30 and overbought market conditions when above 70. It is frequently used by swing traders looking for signals of waning or strengthening momentum in short to intermediate term price movement within a market that are used as indications of a near-term trend change.
Calculating the RSI
Calculation of the RSI, to be done thoroughly, would require a great deal of highly technical and deeply involved explanations. To fully understand how the calculation is accomplished, it is best for traders and analysts to read Wilder’s explanation in his 1978 book, New Concepts in Technical Trading Systems.
However, the index can be broken down into a fairly simple formula:
RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change)]
What to Watch Out For
Traditionally, the Relative Strength Index is considered to signal overbought conditions above 70 and oversold conditions when under 30. The levels can be adjusted, however, to better fit the price movement of the specific security a trader is watching. If, for example, a security’s RSI consistently hits above the 70 mark or below the 30 mark without correctly signaling a change in price trend, it might be a good idea to adjust the upper end to 80 and/or the lower end to 20 to get more reliable trading signals.
Traders should always keep in mind, however, that during periods of very strong trends, a security’s price may continue to rise for a long period of time after an oscillator such as the RSI signals “overbought” conditions in the market. The same caveat applies to extended downtrend price movement that may occur well after an RSI indication of a market being “oversold.”
Bullish and bearish markets play a big role in how the RSI behaves. During a bull market, the index is known to sit in the 40 to 90 range, with the 40-50 range acting as a support. In a bear market, the reading typically stays within the 10 to 60 range, with the 50-60 zone playing the resistance role. The ranges are typical but will be varying based on the settings established for the index, as well as the strength of the underlying market trend for any given security.
In addition to the basic 70/80 or 30/20 readings, traders also watch for the divergence between price movement and movement of the index. When underlying prices hit a new low or high that isn’t supported by a corresponding new low or high in the RSI, this can indicate a pending price reversal in the market.
The Relative Strength Index is among the most popular indicators available to traders, helping them determine potentially good buy entry points (when a security is oversold) and sell exit or entry points (when a security is overbought).
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