The Relative Strength Index (RSI) is a momentum indicator that is used to enhance technical analysis. It is one of the most popular and widely used by traders and analysts momentum indicators. RSI was developed by the famous mechanic engineer and technical analyst J. Welles Wilder*. The indicator is measuring both the speed and rate of recent price changes to identify overbought and oversold positions in the price of an asset.
*Since we already talk about J. Welles Wilder in many of our technical analysis indicators it is important to notice this: All these technical tools are published in his book “New Concepts in Technical Trading Systems” which was published in 1978.
The RSI is displayed as an oscillator, meaning as a line graph that is moving between two extreme prices. The RSI takes on values from zero to 100. An RSI above 70 indicates that a stock is overbought and suggests investors should be cautious. The price is most likely going to fall since it is traded at a higher price than it is supposed to be. For example, Tesla has an RSI of 78, indicating how overvalued the stock is. Moreover, an RSI value of 30 or below indicates an oversold situation. Investors and traders will most of the time jump in to buy these kinds of stocks since they suggest that they have more chances of going up.
The calculation of the RSI is done in two steps. The first step has as follows:
The average gain or loss is calculated as the average percentage of gain or loss during the past period. If the result is lost the formula uses a positive value.
The most common period to use is 14 periods to find the initial RSI value. For example, suppose that the 7-day period out of the 14 had an average gain of 2%. No, suppose that the rest 7 days the average had a loss of -0.5%. The calculation for the first part of the RSI will be done as follows:
In order to calculate the second part of the equation, you need to have 14 periods of data available. The second part of the calculation has as follows:
After the RSI is calculated it should be placed beneath an asset’s price chart.
The RSI will rise when the number and size of positive closes increases. When the number and size of losses increase the RSI will fall. The second part of the calculation comes to smooth the whole calculation and give a clearer understanding.
The trend of an asset is an important tool in order to make the indicator accurate and understandable to the one who uses it. Constance Brown, a famous technical analyst in the financial world, is the one who promoted the basic values of the RSI indicator. He said that in an oversold situation when the RSI in an uptrend it can possibly be higher than 30. Likewise, an overbought situation in a downtrend is much likely to be lower than 70%.
For example, when there is a downtrend on security the RSI will move near the 50% level rather than the 70% (which is the normal value to identify overbought situations). Investors and analysts can still use this indication to signal a bearish situation. Most of its users will usually place a horizontal trend line that is between 30% and 70% levels when a strong trend is happening to help them better identify extremes. The horizontal trend line should be used in the short term because if used in an asset’s price long term the overbought and oversold signals are unnecessary.
The RSI indicator should be best used for bullish signals when the market is in a bullish trend and for bearish signals when the market is in a bearish trend. This is suggested to help eliminate the potential false alarms that can arise from the RSI indicator.
Like already said above the RSI compares the stock price in bearish and bullish price momentum. However, like most of the technical indicators, it can generate false signals and influence the wrong decision for a trader. Therefore, the RSI needs to be used in the correct market conditions.
True reversals are very rare compare to how often there are false alarms of reversals. A false positive for example would be a bullish crossover followed by a fast decline in the price. On the other hand, a false negative would be when there are a bearish crossover and the stock price is all of a sudden inclining.
Remember, since the indicator is showing the momentum, it can easily stay overbought or oversold for a very long time whether the momentum direction is one or the other. Thus, the RSI should be used in an oscillating market where the stock price is alternating from bullish and bearish movements.
When the RSI is indicating an oversold situation meaning 30 or below, then investors should go and buy the stock. An oversold stock is always the best investment since it has more potential to go up or rebound to its normal price. That does not mean that the change will happen immediately. Some stocks tend to trade for some time in an oversold situation until they rebounded.
A sell signal from the RSI will be when the RSI is 70 or above. Stocks like Nike have passed the 70% level many times but haven’t stayed there. However, this does not make it less of an overbought stock. Investors will realize an overbought situation and short it in order to benefit from the reversal. Again, the stock might continue trading in the overbought situation longer time than expected.
For those of you who have already read the MACD indicator the same question must be going in your head. What is the difference between the two? To refresh your memory moving average convergence divergence (MACD) is another trend that follows the momentum indicator. MACD shows the relationship between two moving averages lines of a security’s price. The MACD is subtracting the long line (26-period) from the short line (12-period) and leaves the MACD line.
A signal line is then plotted on top of the MACD line to identify buy or sell signals. A buy signal will be triggered when the MACD line crosses above the signal line. A sell signal will be triggered where the MACD crosses below the signal line.
However, the RSI is designed to identify whether the stock is traded in an overbought or oversold situation. The RSI is calculated given the average price of gains or losses over a period. The default period to use is the 14-day period. The values that the RSI can take are from zero to 100.
Both indicators measure the momentum price of the stock. However, they measure different factors that can influence the trend and sometimes give different results. For instance, the RSI might have a 70% value which means the stock is overbought and traders should sell. At the same time, the MACD could be showing a buying momentum still increasing. Either indicator may signal an upcoming trend change by showing divergence from price (price continues higher while the indicator turns lower, or vice versa).
RSI Divergences give signals for a possible reversal because the direction of the trend does not confirm the price. There is a bullish divergence when oversold reading is seen on RSI. Besides, such oversold reading is accompanied by a higher low level, which corresponds to lower low prices.
Then, that is a bullish divergence. It is a signal for the growth of the bull’s momentum and breaking over the oversold territory can mean starting a new long position. In contrast, a bearish divergence occurs when an overbought reading is seen on the RSI with an accompanying lower high that matches the higher high prices.
This trading tool monitors Relative Strength Index behavior and is useful for signal reversal recognition. This signal is called a bullish “swing rejection”. It is based exclusively on RSI for signal reading. More specifically, RSI behavior is observed when it reappears from an overbought or oversold area. The bullish swing rejection consists of four parts shown below:
In the chart below, you can see that the RSI indicator was oversold, then broke up through 30% and formed the rejection low that triggered the signal when it bounced higher. Using the RSI in this way is very similar to drawing trendlines on a price chart.
Swing rejections can also have a bearish version, as well as divergences. The bearish swing rejection looks like a mirror to the bullish one above. It also consists of the following four parts: