This comprehensive guide will explain the meaning behind the phrase ‘Relative Strength Index.’

What is it?

The ‘Relative Strength Index’ (RSI) is an indicator of momentum that measures the overall magnitude of recent changes to price in order to evaluate overbought or oversold conditions in the price of a particular stock or other assets.

The RSI is typically displayed as an oscillator. This is a technical analysis tool that is essentially a line graph that moves between two specific extremes. It is used on a 14-day timeframe, while you also can get a reading from 0 to 100.

The indicator was originally developed by J. Welles Wilder Jr. and was initially introduced in his 1978 published book, New Concepts in Technical Trading Systems. It was also in the June 1978 issue of Commodities magazine, which is now known as Futures magazine. Since then, it has since gone on to become one of the most popular oscillator indicators.

Using the RSI

The most traditional interpretation and usage of the conventional RSI is that values of 70 or above generally indicate that a security is turning into something overbought or overvalued. This mean basically a current price that is not inherently justified by its earnings outlook, known primarily as profit projections. So it may possibly be ready for a trend reversal or a corrective pullback in price.

An RSI reading that equals 30 or below will typically indicate an oversold or undervalued condition. This refers to a security or any other type of investment that’s selling for a price that’s presumed to be below the true intrinsic value of the investment.

In an uptrend or bull market, the RSI has a tendency to remain in the 40 to 90 range with the 40-50 zone acting as support. During that time there is a downtrend or bear market that the RSI tends to raise in between the 10 to 60 range with the 50-60 zone acting as resistance. These ranges will usually vary depending chiefly on the RSI settings and the strength of the underlying trend of either the security or the market.

The formula

The Relative Strength Index is commonly calculated with a two-part calculation. It begins with this specific formula:

The average gain or loss that is utilized in the calculation is the average percentage of earnings or losses in the midst of a look-back period. The formula harnesses the use of positive values for the average losses.

The concrete model for this protocol is to use 14 periods to compute the original value. Let’s say for example that the market closed higher seven out of the past 14 days with a typical gain of 1%. The seven days that remain all closed lower with an average loss of -0.8%. The calculation relative to the first portion of the RSI would more or less closely resemble the following calculation:

As soon as there are 14 periods of data made available, the second part of the RSI formula can be calculated. The second step of the computation basically smooths out the final results:

Calculation

By using the above-mentioned formulas, the Relative Strength Index is able to be calculated. Thus the RSI line can then be plotted along the side of an asset’s price chart. The RSI will usually rise as the number and the size of positive closes increases. Likewise, it will fall as the number and the size of losses increase.

The second portion of the computation smooths out the final result. So the RSI will only near 100 or 0 in a trending market that is both strong and rapid.

To elaborate, a trending market is defined as being a market that is trending in a specific direction. It should be noted that markets are prone to having bullish, bearish, or even sideways trends.

These particular markets can provide a great number of trading opportunities for technical analysts. The primary job of these individuals is to chart the general price pattern of a security or market index in order to identify trending directions for placing investment trades.

There is the possibility that investors may also follow the trending direction of an index that works as something of a benchmark for a specific type of security. These trending market lines usually function as an overlay to a security price chart. This can aid in helping to form an additional indicator for market trends.

What is a trending market?

To cap off this quick breakdown of what a trending market is, Investopedia editor, James Chen, writes that:

Trending markets are of primary interest in technical analysis. Technical analysts believe that trending markets occur with some degree of regularity and predictability. The ability to correctly discern these trends can have a substantial impact on investment returns.”

The RSI can often remain in the ‘overbought’ territory for an extended period of time all the while stock is in an ‘uptrend’.

An uptrend is the price movement of a particular financial asset when the overall direction is moving upward. In an uptrend, each successive ‘peak and trough’ (patterns that are developed by the price action experienced by all securities) is considerably higher than those earlier in the trend.

The indicator is able to stay in the ‘oversold’ territory for a very long time. During this time a stock might be in the midst of a ‘downtrend.’ This is what occurs whenever the overall price of an asset moves lower over a period of time. While admittedly this can be fairly confusing for new analysts, learning to properly use the indicator within the context of the predominant trend will surely clarify these puzzling issues.

What does it tell you?

You might be wondering what exactly this index conveys to its users. Well, the primary trend of the stock or asset is an incredibly vital tool in making sure that the indicator’s readings are properly understood and acknowledged.

For instance, Constance Brown, a well-known and acclaimed market technician, has promoted the general idea that a reading that’s classified as oversold on the RSI in an uptrend is likely going to be much higher than 30%. Also, a reading that’s identified as overbought on the RSI during a downtrend is much lower than the 70% level.

Charting RSI

Based on the chart that’s shown below, during the period of a downtrend, the Relative Strength Index will typically peak near the 50% level as opposed to 70%. This could potentially be utilized by investors as a way to signal bearish conditions in a much more reliable fashion.

A number of investors will sometimes apply a horizontal trendline that resides between 30% and 70% levels whenever a strong trend is in place in order to better identify the extremes. The act of modifying overbought or oversold levels whenever the general price of a stock or asset is in a long-term, ‘horizontal channel’ is usually deemed as necessary.

These horizontal channels are trendlines that connect changing pivot highs and lows. They show the price between the upper line of resistance and the lower line of support. In addition, a horizontal channel is also a price range or a sideways trend. Chen explains that:

The horizontal channel is a familiar chart pattern. It’s found on every time frame. Buying and selling forces are similar in a horizontal channel and only the breakout of one of the two bands will show an advantage to one of them. The horizontal channel is a powerful yet often overlooked chart pattern. It combines several forms of technical analysis to provide traders with precise points for entering and exiting trades, as well as controlling risk.”

A connected concept to utilizing overbought or oversold levels that are appropriate to the trend is to focus primarily on trading signals and techniques that adjust to the trend. Strictly speaking, using bullish signals whenever the price is within a bullish trend and bearish signals whenever a stock is in a bearish trend will assist in avoiding the numerous false alarms the RSI can generate.

Examples of indicators

The following is a couple of examples of how to use the RSI.

Divergence

The bullish divergence is the time in which the price of an asset is moving in the opposite direction of a technical indicator, such as the previously discussed oscillator. It occurs whenever the RSI creates an oversold reading. Additionally, it’s followed by a higher low that matches accordingly to lower lows in the price.

This typically indicates increasing bullish momentum. Also, it means a break above the oversold territory could potentially be a means to trigger a new long position. Essentially, this entails the purchase of a security like a stock, commodity, or currency. Only with the exception that the asset will eventually rise in value.

A bearish divergence will occur whenever the RSI constructs an overbought reading that is followed by a lower high that matches correspondingly to higher highs on the price.

As you can clearly see on the chart below, a bullish divergence was recognized. The RSI formed higher lows as the price assembled lower lows. This was a completely valid signal. However, divergences can be pretty rare whenever a stock is in a stable long-term trend. By using flexible, oversold or overbought readings, it will assist in identifying more valid signals that would otherwise be obvious.

Swing Rejections

Another notable trading technique examines the RSI’s general behavior when it is re-emerging from overbought or oversold territory. This particular signal is referred to as a bullish “swing rejection”. It possesses four parts:

  1. RSI falls into the oversold territory.
  2. Then it crosses back above 30%.
  3. Next, RSI formulates another dip without crossing back into the oversold territory.
  4. RSI then breaks its previous (most recent) high.

Based on the following chart, the RSI was oversold. It broke up through 30% and formed the rejection low that instigated the signal when it bounced higher. By using the RSI in this way, it is very similar to drawing trendlines onto a price chart.

Much like divergences, there is a bearish version of the swing rejection signal. It looks a lot like a mirror image of the bullish version. A bearish swing rejection is also made up of four parts:

  1. RSI rises into overbought territory.
  2. Then is crosses back below 70%.
  3. Next, RSI creates another high without crossing back into overbought territory.
  4. RSI then breaks its previous (most recent) low.

The chart below shows the bearish swing rejection signal. As is the case with most trading techniques, this signal will be the most reliable when it conforms to the prevailing long-term trend. Bearish signals within negative trends are less likely to generate a false alarm.

MACD: what’s the difference?

There’s another trend-following momentum indicator that exists, called the Moving Average Convergence Divergence (MACD). It shows the relationship between two moving averages of a security’s price. So what’s the difference between this and the RSI?

The MACD is typically calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA. The result of that computation is something called the MACD line. A nine-day EMA of the MACD – the ‘signal line’ – is then plotted on top of the MACD line, which can serve as a trigger for buy and sell signals. Traders may purchase the security whenever the MACD crosses above its signal line and sell the security when the MACD crosses below the signal line.

The RSI’s goal is to indicate whether a market is considered to be overbought or oversold in relation to the most recent price levels. Thus the RSI will calculate the average price gains and losses over a given period of time. The default time period is commonly 14 periods with values that bounded from 0 to 100.

Basically, the MACD measures the relationship between two EMAs. Alternatively, the RSI measures changes in price related to recent price highs and lows.

The limitations

As to be expected, there are limitations to the RSI.

It compares bullish and bearish price momentum and displays results in an oscillator placed alongside a price chart. Much like with most technical indicators, its signals are the most trustworthy whenever they adjust to the long-term trend.

True signals of reversal are pretty rare and can be difficult to separate from a false alarm. For example, a false positive would be a bullish crossover that’s followed by a decline in a stock. A false negative would usually be a situation where there’s a bearish crossover, yet the stock accelerated upward.

Seeing as how the indicator displays momentum, as long as the asset’s price momentum remains strong (whether it be up or down), then the indicator can stay in overbought or oversold territory for a long time. As a result, the RSI is at its most reliable in an oscillating market whenever the price fluctuates between bullish and bearish periods.

Conclusion

RSI is an intricate mechanism, but an important one nonetheless. There’s a lot that can be said about it and this article hopefully functioned as the perfect introduction. To learn more about market trends, check out our article on trend trading.

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