Relative Strength Index (RSI)
By Marcus Fei

What is it?

Developed by J. Welles Wilder Jr., RSI was published in his 1978 classic "New Concepts in Technical Trading Systems".

Essentially, RSI is a form of a smoothed momentum indicator. The term “relative strength” in this case is sometimes considered as a misnomer as RSI is not used to compare between two different instruments as the term “relative strength” would normally indicate. RSI’s formula takes into the consideration of the average closes of X number of up days and the average closes of X number of down days to determine a momentum number that ranges between 0 and 100. Plotted over time, RSI would resemble a line that fluctuations between 0 and 100.

At TradeSignum.com, whenever RSI is selected, the default value of 14-periods is selected.

What is it used for?

RSI is popularly used to identify potential buy and sell situations through overbought and oversold situations. It can be used to spot potential trend reversals through positive and negative divergences as well as the breaking of its own trendlines.

How to use it?

The first use of RSI is to determine overbought and oversold levels. Generally, it is considered to be oversold when RSI dips below 30 and overbought when RSI crosses above 70. However, in strong trending periods, RSI may stay overbought/oversold for an extended period of time and as such buy signals are only given when RSI crosses back above the 30 line from below and sell signals are given only when RSI crosses below the 70 line from above. It has also been suggested overbought/oversold signals are more reliable under range trading than non-trending periods.

Overbought and Oversold Signals

 

Using RSI, we can also gauge the momentum of a current market direction. When momentums in current market directions start to fail, positive and negative divergences can be spotted across the price and RSI levels. Such divergences are also known as "Failure swings". A bottom failure swing is a bullish indicator of a possible market bottom, occurs when the price continue to drop to new lows while RSI does not move in tandem and does not record new lows. A top failure swing is a bearish indicator of a possible market top, occurs when prices continue to climb higher to new highs while RSI does not gain in tandem and fails to record new highs. Wilder considers divergences between RSI and then price line when RSI is below 30 or above 70 as the single most indicative characteristic of the RSI and should be considered as a serious warning whenever spotted.

Bottome Failure Swing Top Failure Swing

 

Trendlines can also be used in conjunction with the RSI line. A buy signal is given when RSI breaks above its downward trendline and a sell signal is given when RSI breaks below its upward sloping trendline.

RSI Trendlines

 

Conclusion

Depending on your style of trading, whether you are a momentum trader or range trader, RSI can help you identify better trading decisions. As with other technical systems, RSI has its strengths and weaknesses and will perform well in one market environment and may not do so well in another. Hence understanding when to RSI and how to use it in conjunction with other technical indicators will most definitely help us to determine more profitable trades.

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