21. ( RSI ) Relative Strength Index

Relative strength Index or just RSI, is a very popular indicator developed by J.Welles Wilder. RSI is a leading momentum indicator which helps in identifying a trend reversal.

The Relative Strength Index (RSI) is an oscillator that measures current price strength in relation to previous prices. The RSI is a versatile tool, it can be used to:

• Generate buy and sell signals
• Show overbought and oversold conditions
• Confirm price movement
• Warn of potential price reversals through divergences

Formula

The formula to calculate the RSI is as follows:

Let us understand this indicator with the help of the following example:
Assume the stock is trading at 99 on day 0, with this in perspective; consider the following data points:

In the above table, points gained/lost denote the number of points gained/lost with respect to the previous day close. For example if today’s close is 104 and yesterday’s close was 100, points gained would be 4 and points lost would be 0. Similarly, if today’s close was 104 and previous day’s close was 107, the points gained would be 0 and points lost would be 3. Please note that, the loses are computed as positive values.
We have used 14 data points for the calculation, which is the default period setting in the charting software. This is also called the ‘look-back period’. If you are analyzing hourly charts the default period is 14 hours, and if you are analyzing daily charts, the default period is 14 days.
The first step is to calculate ‘RS’ also called the RSI factor. RS as you can see in the formula, is the ratio of average points gained by the average points lost.
Average Points Gained = 29/14
= 2.07
Average Points Lost = 10/14
= 0.714
RS = 2.07/0.714
= 2.8991
Plugging in the value of RS in RSI formula,
= 100 – [100/ (1+2.8991)]
= 100 – [100/3.8991]
= 100 – 25.6469
RSI = 74.3531
As you can see RSI calculation is fairly simple. The objective of using RSI is to help the trader identify over sold and overbought price areas. Overbought implies that the positive momentum in the stock is so high that it may not be sustainable for long and hence there could be a correction. Likewise, an oversold position indicates that the negative momentum is high leading to a possible reversal.


The chart below shows how the RSI can generate easy to follow buy and sell signals:

 

RSI Buy Signal

Buy when the RSI crosses above the oversold line (30).

RSI Sell Signal

Sell when the RSI crosses below the overbought line (70).

Varying the time period of the Relative Strength Index can increase or decrease the number of buy and sell signals. In the chart below of Gold, two RSI time periods are shown, 14-day (default) and 5-day. Notice how decreasing the time period made the RSI more volatile, increasing the number of buy and sell signals substantially.

There is another way the Relative Strength Index gives buy and sell signals. Given Below-

RSI Divergences

An alternative way that the Relative Strength Index (RSI) gives buy and sell signals is given below:

• Buy when price and the Relative Strength Index are both rising and the RSI crosses above the 50 Line.
• Sell when the price and the RSI are both falling and the RSI crosses below the 50 Line.

An example of this methodology for buying and selling based on 50 Line crosses is given below in the chart-

 

For another interesting and under-utilized method for using the RSI indicator for buy and sell signals, see: Stochastic RSI, which combines both the popular Stochastics indicator and the Relative Strength Index. 

Relative Strength Index Confirmations & Divergences

A powerful method for using the Relative Strength Index is to confirm price moves and forewarn of potential price reversals through RSI Divergences.

The chart below contract shows the RSI confirming price action and warning of future price reversals:

Low #1 to Low #2

The E-mini Nasdaq 100 Futures contract's price made a substantial move from Low #1 to Low #2. The RSI confirmed this move, helping a trader have confidence jumping on board the price move higher. The break of trendline of the e-mini future was also confirmed by the trendline break of the Relative Strength Index, confirming that the price move was likely over.

Low #3 to Low #4

A bullish divergence was registered between Low #3 and Low #4. The e-mini Nasdaq 100 future made lower lows, but the RSI failed to confirm this price move, only making equal lows. An astute trader would see this RSI divergence and begin taking profits from their shortsells.

High #1 to High #2

A bearish divergence occured when the e-mini futures contract made a higher high and the RSI made a lower high. This bearish divergence warned that prices could be reversing trend shortly. A trader should consider reducing their long position, or even completely selling out of their long position. The Relative Strength Index is a popular tool for generating buy and sell signals, confirming trends, and warning of impending price reversals.

Note

None of the parameters used while analyzing RSI should be treated with rigidity. For example, J.Welles Wilder opted to use a look back period of 14 days simply because that was the value which gave the best results considering the market conditions in 1978 (which is when RSI was introduced to the world). You may choose to use 5,10,20, or even 100 days look back period if you wish too. In fact this is how you develop your edge as a trader. You need to analyze what works for you and adopt the same. Please note, fewer the days you use to calculate the RSI, the more volatile the indicator would be.
Also, J.Welles Wilder decided to use 0-30 level to indicate oversold regions and 70-100 level to indicate overbought region. Again this is not set in stone, you can arrive at you own combination.
I personally prefer to use 0-20 level and 80-100 level to identify oversold and overbought regions respectively. I use this along with the classical 14 day look back period.
Of course, I urge you to explore parameters that work for you. In fact this is how you would eventually develop as a successful trader.
Finally, do remember RSI is not used often as a standalone indicator by  traders, it is used along with other candlestick patterns and indicators to study the market.

Key takeaways 

1. Indicators are independent trading systems developed, and introduced by successful traders
2. Indicators are leading or lagging. Leading indicators signals the possible occurrence of an event. Lagging indicators on the other hand confirms an ongoing trend
3. RSI is a momentum oscillator which oscillates between 0 and 100 level
4. A value between 0 and 30 is considered oversold, hence the trader should look at buying opportunities
5. A value between 70 and 100 is considered overbought, hence the trader should look at selling opportunities
6. If the RSI value is fixed in a region for a prolonged period, it indicates excess momentum and hence instead of taking a reversed position, the trader can consider initiating a trade in the same direction.