The Relative Strength Index or RSI is one of the most known indicators in technical analysis.
Created by J. Welles Wilder and first popularized in the 1970s and throughout the 1980s, it is typically called a momentum indicator or an overbought/oversold indicator. Its calculation is based on change in the movement of price, as depicted by the following formula:
RSI = 100 –
1 + RS
Where RS is the product of the average gain divided by the average loss over a certain period of time.
The value of RSI runs between 0 and 100.
In analyzing charts, this indicator can be used in several ways (including but not limited to):
Support and resistance levels
Tops and bottoms (overbought/oversold)
Support and Resistance Levels
Charts are often filled with lots of bars or candlesticks and this bunch of price points contributes to what is called market noise. The RSI indicator can help in getting rid of some of that noise and detect good support and resistance levels.
RSI is one of several indicators that can help detect divergences and hence, possible reversals in price. A divergence is a price condition wherein the price is moving in a certain direction that is not reflected in an indicator. For example, if price continues to move up but RSI diverges by moving down, then you have a condition called a bearish divergence. This means that price is expected to move down soon. If price has continued to move down but RSI instead diverges and continues to rise, then you have a bullish divergence. This means that price is expected to move up soon. The angle of the divergence line doesn’t have to be steep to be considered a divergence, as seen in the example image below (bullish divergence in red, bearish divergence in blue). The chart below shows (left) that price has created a lower low but RSI stayed flat; price reversed soon after. On the right, you would see price making 3 consecutive highs, but the indicator instead made lower lows.
Detecting Tops and Bottoms (overbought/oversold)
As mentioned above, RSI is considered an overbought/oversold indicator, because it can help define tops and bottoms seen in the price chart. An RSI reading of 70 and above is considered overbought (or when price is likely topping out), while a reading of 30 and below is considered oversold (or when price is likely bottoming out).
Some traders use several indicators in their charts. Some even put one indicator on top of another, or what is called an “overlay” (sometimes in order to save chart space). An overlay helps combine the use of two indicators in technical analysis. (Note: You should be careful in choosing which indicators to combine and whether to use an overlay -- this can contribute to analysis paralysis. Sometimes simple is better) In the image below, a red RSI 5 was overlaid on top of a blue RSI 20.
Despite the constant change in the market’s volatility, the Relative Strength Indicator has remained simple yet useful in making sense of what’s happening in the price charts. Therefore, it is one indicator worth considering and adding in a technical trader’s toolbox.
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