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The Relative Strength Index was created by J. Welles Wilder. It is the most popular momentum indicator, which measures internal potential of
security. As well as the ROC, the RSI attempts to identify overbought or oversold conditions.
Relative Strength Index compares the downward to the upward price movement over the
The RSI compares the upward price movement to downward price movement over the definite period, and under certain conditions goes from 0 to 100.
Formula Relative Strength Index
The formula for a Relative Strength Index is as follows:
100-100/[(Upward price movement/Downward price movement)+1], where
Up price movement - is the average number of closes that are higher than the previous close.
Downward price movement is the average number of closes that are lower than the previous close.
Parameters RSI
J. Welles Wilder suggests using 14 periods. But in accordance with practice sometimes it’s not effective. Experienced traders recommend using Fibonacci numbers for specified timeframe.
As for overbought/oversold levels respectively, Wilder suggest using 30 (oversold area) and 70 (overbought area).
How to trade…
There are two basic methods Relative Strength Index are used, which can be powerful depending on the trading approach and on the market conditions as well.
First way
First way is to get buy/sell signals based on crossover overbought/oversold levels. It was generally considered that when the index was higher that 70 (or 80) there existed an overbought condition, and when it was less than 30 (or 20), an oversold condition.
However, practical studies have shown that use of the levels 70 and 30 as the signals to sell or buy were not very effective.
Crossovers can help indicate the dynamics of price movements. When RSI crosses below 50 –it’s considered a signal for an downtrend and when it crosses above 50 – it’s considered a signal for an uptrend.
Second Way
Another way is to find signals that generated when there are divergences between Relative Strength Index and price movement.
Bullish divergences happen when the price makes a new low is in oversold (20-30) area and that is not confirmed by a new low in the Relative Strength Index.
Bearish divergences happen when the price makes a new high is in overbought (70-80) area and that is not confirmed by a new high in the Relative Strength Index. It potentially signals a market top.
Mr. Wilder suggested additional rules based on visual analysis.
One – RSI charts form basic patterns such as Head & Shoulders, Double Top, etc., which are not noticeable on a price chart.
Two – Lines as support and resistance are also identified on the RIS charts and not on a price chart.
Three- Divergences are very reliable sign of a future change in trend.
A Divergence occurs when there is different interpretation between the RIS movement and the price movement. The chart shows that the price reaches a new high, although the RSI does not confirm this direction of movement.
Failure Swings are the breaking through of support or resistance lines as reflected on an RSI chart, but not on a price chart.
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