RSI (Relative strength index)
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The Relative strength index (RSI), developed by J. Wells Wilder in 1978, is an impulse oscillator that measures the speed and change in price movements. Step-by-step instructions on calculating and interpreting the RSI are also provided in Mr. Wilder's book 'New Concepts in Technical Trading Systems'. The RSI fluctuates between zero and 100. Traditionally, the RSI is considered overbought when it is above 70 and oversold when it is below 30. Signals can be generated by looking for divergences and bad swings. RSI can also be used to determine the overall trend.
When Wilder introduced the Relative strength index, he recommended using a 14-period RSI. Since then, the 9- and 25-period Relative strength index indicators have also gained popularity. A popular method of analyzing RSI is looking for a divergence in which the security makes a new high, but the RSI cannot surpass its previous high. This divergence is an indication of an impending reversal. When the Relative strength index then turns down and falls below its most recent trough, it is said to have completed a "failure swing". The failure swing is considered a confirmation of the impending reversal.
The following signals of Relative strength index are used in chart analysis:
Tops and Bottoms
The Relative strength index usually tops above 70 and bottoms below 30. It forms these tops and bottoms before the underlying price chart.
Chart Formations
RSI often forms chart patterns such as head and shoulders or triangles, which may or may not be visible on the price chart.
Failure Swing (Support or Resistance breakout)
This is where the Relative strength index exceeds the previous high (peak) or falls below the recent low (trough).
Support and Resistance levels
The Relative strength index shows, sometimes more clearly than the price itself, levels of support and resistance.
Divergences
As discussed above, divergences occur when price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative strength index. Prices are usually correcting and moving in the direction of the RSI.
The basic formula for calculating the Relative strength index is as follows:
RSI = 100 - (100 / (1 + U / D))
Where:
U — average number of positive price changes;
D — average number of negative price changes.
Period – number of periods involved in the indicator calculation, the default value is 14;
Type of moving average involved in the calculation, available values: Simple, Exponential, Modified, Linear weighted.
The indicator looks as follows on the chart:
