The Relative Strength Index (RSI), is one of the most popular indicators used in Technical Analysis. Firstly Introduced in J. Welles Wilder’s book, “New Concepts in Technical Trading Systems”, the RSI is a momentum oscillator that measures the velocity of directional price movement and scaled between 0-100. In the classic view, security is thought to be overbought when its RSI reading is above 70 and oversold when its RSI reading falls below 30.
# How is it Calculated?
The equation for the Relative Strength Index, RSI, is:
For the first calculation of the Relative Strength Index, RSI, we need the previous 14 day’s close prices. The initial RSI is calculated as follows:
- Obtain the sum of the UP closes for the previous 14 days and divide this sum by 14. This is the average UP close.
- Obtain the sum of the DOWN closes for the previous 14 days and divide this sum by 14. This is the average DOWN close.
- Divide the average UP close by the average DOWN close. This is the Relative Strength (RS).
- Add 1.00 to the RS.
- Divide the result obtained in Step (4) Into 100 (100 is the nominator).
- Subtract the result obtained in Step 5 from 100. This is the first RSI.
From this point on, it is only necessary to use the previous average UP close and the previous average DOWN close in the calculation of the next RSI.
# How to Use it Correctly
If used properly, the RSI can be a very valuable tool in interpreting chart movement.
Tops and Bottoms: These are indicated when the Index goes above 70 or below 30. The Index will usually top out or bottom out before the actual market top or bottom, giving an indication that a reversal or at least a significant reaction is imminent.
Failure Swings: When the RSI crosses down the 70 level and rebounds back up yet fails to reach the previous high. The low point made when the RSI rebounded is considered as a potential short entry point when the RSI moves below this level. Conversely, when the RSI crosses up over the 30 level and rebounds back down but fails to move as low as the previous low reading, it is a failure swing. The peak made when the RSI rebounded is considered a potential long entry point when the RSI moves above this level.
Support and Resistance: Areas of support and resistance often show up clearly on the RSI before becoming apparent on the bar chart. In fact, support and resistance lines drawn using the RSI points are often analogous to trend lines drawn using bar chart points.
Divergence: Divergence between price action and the RSI is a very strong indicator of a market turning point. Divergence occurs when the RSI is increasing while the price movement is either flat or decreasing. Conversely, divergence occurs when the RSI is decreasing price movement is either flat or increasing.
Here is an example of a bullish divergence on BTC/USD (Bitcoin) which signaled the bullish trend occurred after that:
As you can see, a bullish divergence formed in November-December of 19. The bullish divergence formed with Bitcoin moving to new lows in December and RSI holding above its prior low. The mid-December breakout confirmed improving momentum. Divergences tend to be more robust when they form after an overbought or oversold reading.
The Relative Strength Index (RSI), used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart trader. No single tool, method or system is going to produce the right answers 100% of the time. A successful trader utilizes several different kinds of input into his decisions. The Relative Strength Index can be a valuable input to your toolbox and into your decision-making process.
- The RSI is a momentum oscillator (oscillator is a line graph that moves between two extremes).
- It is scaled between 0 – 100.
- When the RSI reading is above 70 it usually considered overbought and when it falls below 30 it usually considered oversold.
- The standard is to use 14 periods to calculate the initial RSI value, but you can choose the time frame you think fit the most.