Relative strength index, or as commonly called, RSI, is a momentum based oscillator developed by J. Welles Wilder, Jr.
RSI is used to determine trend reversal opportunities in a market. Like other technical indicator oscillators, RSI is also used to measure markets being oversold or overbought. RSI being a momentum based oscillator operates on a scale of 0 to 100. The closer RSI is to 0, the more oversold the stock is said to be and the closer it is to 100, the overbought it is. As a rule of thumb, if RSI drops below 30, it implies a oversold stock or that the bear run is near its end; conversely, RSI above 70 suggests an overbought or weakening bull market.
But, immediately selling when the RSI is above 70 or buying when the RSI is below 30 can be a risky trading system. A move to these levels is better utilized if used as a signal for determining market/stock top or bottom. But it does not, in itself, indicate a top or a bottom.
The RSI chart exhibits chart formations as well. Common bar chart formations readily appear on the RSI study. They are trend lines, head and shoulders, and double tops and bottoms. In addition, the study can highlight support and resistance zones.
Different Ways of Using RSI:
- As discussed before, RSI usually tops above 70 and bottoms out below 30. It forms these tops and bottoms usually before the price chart.
IfRSI(CLOSE, 14) < 30 = Normal Over Sold
IfRSI(CLOSE, 14) < 20 = Semi Strong Over Sold
IfRSI(CLOSE, 14) < 10 = Strong Over Sold
IfRSI(CLOSE, 14) > 70 = Normal Over Bought
IfRSI(CLOSE, 14) > 80 = Semi Strong Over Bought
IfRSI(CLOSE, 14) > 90 = Strong Over Bought
- Also as shown above, the RSI also forms chart patterns such as double tops and bottoms, head and shoulders and others which may or may not be visible on price chart.
- Another good way of using RSI is using crossovers of RSI and RSI average.
- Failure Swing:
Failure swings are nothing but Support or Resistance zones’ penetrations and breakouts. This is where the RSI surpasses a previous high or falls below a previous low.
When there is a difference between what the price action is indicating and what RSI is indicating, it is said that RSI Divergence occurs. These differences are strong signs of reversals.
- Bullish RSI Divergence – When price makes a new low but RSI makes a higher low.
- Bearish RSI Divergence – When price makes a new high but RSI makes a lower high.3
Wilder believed that Bearish divergence creates a selling opportunity while Bullish Divergence creates a buying opportunity.
For a long time now, RSI has proved to be extremely valuable for any serious technical analyst.But, it has to be said that assuming which direction market will go based on just look at RSI number is a sign of novice trader rather than professional trader. One should always research and experiment with the indicator according to one’s own style of trading before relying on it as a sole decision maker for trading.
But, when used in proper perspective, RSI has proven to be a core and reliable indicator.