Relative Strength Index, RSI

Relative Strength Index, RSI

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The Relative Strength Index Technical Indicator (RSI) is a price-following oscillator that ranges between 0 and 100. When Wilder introduced the Relative Strength Index, he recommended using a 14-day RSI.. Since then, the 9-day and 25-day Relative Strength Index indicators have also gained popularity.

A popular method of analyzing the RSI is to look for a divergence in which the security is making a new high, but the RSI is failing to 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.


Ways to use Relative Strength Index for chart analysis:
* Tops and bottoms
The Relative Strength Index usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart;
* Chart Formations
The RSI often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart;
* Failure swing (Support or Resistance penetrations or breakouts)
This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough);
* Support and Resistance levels
The Relative Strength Index shows, sometimes more clearly than price themselves, levels of support and resistance.
* Divergences
As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index. Prices usually correct and move in the direction of the RSI.

RSI indicator Formula
RSI = 100 - (100 / RS + 1)
where:
RS = Average Upward Price Change / Average Downward Price Change
Average Upward Price Change = [(previous Average Upward Price Change) x 13 + current Upward Change] / 14
First Average Upward Change = Total of Upward Changes during past 14 periods / 14
Average Downward Price Change = [(previous Average Downward Price Change) x 13 + current Downward Change] / 14
First Average Downward Change = Total of Upward Changes during past 14 periods / 14
• For calculation Downward Price Changes are taken as positive values.

Trading with RSI indicator involves the following signals:
RSI moving above 50 level — uptrend is confirmed, below 50 — downtrend is confirmed.
RSI peaking above 70 level — market is overbought.
RSI staying above 70 level — uptrend is running strong.
RSI exiting 70 level — downtrend is underway, or at least a correction down is due.
Same for RSI falling below 30:
below 30 — market is oversold,
staying below 30 — downtrend is running strong,
exiting above 30 — uptrend is underway, or at least an upward correction is due.
RSI diverging from price on the chart — an early warning of a possible trend change.

Details
RSI - Relative Strength Index Indicator - is another great momentum indicator developed by Welles Wilder.
Standard period settings for RSI is 14 periods, which can be applied to any time frame.
RSI indicator compares the average of up and down closes for a specific period of time.
RSI indicator is famous for displaying a momentum when market is being overbought or oversold, which creates a potential for trend reversal.

How to trade with RSI indicator
RSI indicator is known as overbought/oversold indicator, however, RSI doesn't provide "buy/sell" signals upon indicating oversold/overbought areas, there are certain rules, which help to identify the right timing for entries and exits.
In order to identify those overbought and oversold moments Forex traders look at two RSI levels: 30 and 70. Readings above 70 indicates an overbought market. While readings below 30 indicates an oversold market.

However, once RSI exceeds 70 it is not going to be a signal for immediate Selling, since RSI may stay in overbought/sold area for a long-long time.
Many traders would also say, that when the uptrend is strong, readings above 70 is just a beginning of a great upward move; opposite true for downtrend and readings below 30.

In order to enter at the right moment on the true market reversal traders should wait for RSI to leave overbought/sold zone. For example, when RSI goes above 70, Forex traders would short their positions and close existing Long trades when RSI crosses down below 70.

Opposite true for oversold RSI readings. Once RSI went below 30, traders wait for indicator to come out of oversold zone and rise above 30 before placing Buy orders.
RSI also has 50 level, which separates buying forces from selling forces on the market.

RSI Divergence trading
Another way to exploit RSI is to take advantage of RSI divergence signals.
When RSI approaches 30 look for bullish divergence => slowly rising RSI versus still declining prices.

When RSI approaches 70 traders watch for bearish divergence, which occur when actual RSI readings begin to decline while prices continue climbing up. RSI Divergence suggests that current momentum is over and traders should look to protect their profits and be ready to trade in the opposite direction.

The best way to learn about any indicators is to read original works of their creators.
Therefore, let's turn to the book where J. Welles Wilder tells about his research on RSI indicator:
"(3) Failure Swings: Failure swings above 70 or below 30 are very strong indications of a market reversal.
"(5) Divergence: Although divergence does not occur at every turning point, it does occur at most significant turning points. When divergence begins to show up after a good directional move, this is a very strong indication that a turning point is near. Divergence is the single most indicative characteristic of the Relative Strength Index."