RSI

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Relative Strength Index Description

The RSI (Relative Strength Index) is one of the most popular momentum oscillators in technical analysis use today; it was introduced in a 1978 book by J. Welles Wilder. The main point in development of the RSI was to spot periods of fast and rapid moves up and drops down.

The author of the RSI recommends a standard setting of 14 bars to calculate the average gain and loss; however, it is important to remember that the Average Gain and the Average Loss do not represent true averages! Total gains (losses) are always divided by the specified number of time periods 14 in this case, instead of the number of gaining (losing) periods.

RSI Technical Analysis, Signals and Trading Systems

70 and 30 are the most commonly used RSI levels for a market considered to be "overbought" or "oversold", respectively. Basically, the RSI is a measure of the strength of a recent trend:

• RSI is considered strongly bullish if the RSI exceeds 70 this means the security (index, stock, ETF) has trended up strongly over the past analyzed period. Some would consider the security to be overbought at these levels, and a potential selling point might thus be reached when the RSI exceeds 70;
• If the RSI is between 50 and 70, the security has moved up over the past analyzed period; however, the uptrend has not been very pronounced;
• If the RSI is between 30 and 50, the security has moved down over the past analyzed period; however, the downtrend has not been very strong;
• If the RSI is below 30, the security has trended strongly lower over the past analyzed period and the RSI is considered strongly bearish. Some would consider the security to be oversold at these levels, and an RSI reading below 30 might thus mark a potential buying point.

As is the case with many price indicators, the RSI may generate false signals at times. A market will not always turn when the RSI exceeds 70 or when it trades below 30. When we see volume surges in conjunction with a strong market advance or decline, the probability of a reversal becomes much higher.

You have to understand, when the RSI moves above 70% or drops below 30% and when your analyzed stock (index) is considered overbought or oversold respectfully, it does not necessary mean that you will see immediate trend reversal. A stock may remain in overbought condition and its price may continue to move up. Controversially, a stock may continue to decline by remaining in oversold condition. Furthermore, technical analysis recommends selling not when RSI moves above 70% level, but when it drops below it after previously being above. This could be interpreted like: "a stock after being in overbought condition started to move down and it could be a sign that buying power of the bullish traders became exhausted". In similar way, an event when RSI moves above 30% level after being below could be explained as "a stock after being in oversold condition started to move up and it could be a sign that selling power of the bearish traders became exhausted". A simple trading system based on RSI technical analysis would tell:

• Buy when RSI  drops below 70% after being above it;
• Sell when RSI moves above 30% after being above it.

Below on the Dow Jones Industrials (DJI) chart below you may see an examples of the simple trading system's rules described above.

Chart 1: Dow Jones Industrials (^DJI) - RSI (12)


Some traders may prefer other than 30 and 70% levels as signals triggering levels. Another popular way to generate trading signals is to do it on the crossovers of the RSI and 50% center-line around which RSI oscillates by assuming that RSI reading above 50% level is a sign of Bullish trend while readings below 50% reveal Bearish trend. In this case simple trading system would suggest to:

• Buy when RSI moves above 50%,
• Sell when RSI drops below 50%.

The following is a simple trading system based on combining the RSI with our volume indicators:

1. When the RSI rises above 70, sell on a significant volume surge.
   As a general rule, volume surges that appear during strong index advances - (i.e., when the RSI > 70) - indicate potential downside reversals;
2. Buy on a significant volume surge when the RSI drops below 30.
3. As a rule general, volume surges that appear during strong index declines (i.e., when the RSI < 30) - indicate potential upside reversals;
4. Ignore volume surges that appear when the RSI remains between 30 and 70. Under such circumstances, market reactions may be short-lived.

RSI Formula and Calculations

The RSI compares the magnitude of recent gains to the magnitude of recent losses. Results are represented in a range between 0 and 100. The RSI is calculated by means of the following formula:

RSI = 100 - 100 / (1 + RS)

Where RS is the ratio between the average gains and average losses over a specified period:

RS = (Average Gains) / (Average Losses)

Average gain and losses are calculated as average price change for positive and negative trading session. As an example when 14-bar period selected for the RSI:

Average Gains = SUM (Price Change of positive bars within past 14 bars) / 14

Average Loss = SUM ( Absolute value of (Price Change of negative bars within past 14 bars)) / 14