The Relative Strength Index is an oscillator that measures the strength or weakness of a stock or asset by comparing its daily up movements versus its daily down movements over a given time period. The oscillator can trend, reach extreme levels and form divergences from actual price action. Each of these actions can supply traders with potentially useful
Relative Strength Index Components
The Relative Strength Index is most commonly thought of as an oscillator, because it fluctuates up and down within a bounded range of values. On a price chart, the RSI indicator is plotted as a single line that is calculated by combining the following information over a given period:
• The average gain for a stock during advances within a set time period
• The average loss for a stock during declines within a set time period
A ratio of these two values is used to create a measure that moves between 0% and 100%. Relative Strength Index readings over 50% indicate price movement that is generally rising, while readings below 50% indicate price movement that is generally declining. The most common time period setting for the Relative Strength Index is 14 periods, although many traders utilize different values, typically ranging from as low as 2 periods to as high as 25 periods.
Indicator Signals: What Traders Look for
1. Convergence/Divergence (Trend Strength/Weakness)
• Convergence – RSI that follows in the same direction of the trend signifies potential trend strength and increasing speed of the trend.
• Divergence - RSI that moves in the opposite of the trend’s direction over a period of time signifies potential trend weakness and/or decreasing trend momentum.
2. Overbought/Oversold (Trend Reversal)
As price declines unfold RSI typically trends towards 0%. On the other hand, as price rises RSI typically trends toward 100%. The more extreme the values, the more “overbought” or “oversold” the stock or asset is considered to be. For most traders:
• The upper range above 70% indicates overbought conditions
• The lower range below 30% indicates oversold conditions
One of the most common ways this indicator is used by traders is simply to wait for RSI to reach an overbought or oversold level and treat it as an alert that the speed and momentum of the trend may soon run out of momentum. It is important to remember that a simple movement by RSI into an overbought or oversold region does not necessarily signal that a price reversal is imminent, only that the possibility exists. As with any technical analysis signal, it can be useful to wait for confirmation of a change in trend before taking action.
During a downtrend, there are two ways RSI signals a potential bullish price reversal upward to the upside.
1. Bullish Oversold Signal (Trend Reversal)
A bullish oversold signal occurs when the RSI falls to an oversold level (30% or less), and then rises back above it, generating a signal that bullish sentiment may be gaining momentum.
2. Bullish Trend Alert (Trend Confirmation)
A bullish trend alert occurs when the RSI rises from below to above the neutral 50% level. This is more useful when using an RSI time period of 14 days or more than when using less than 14 days.
3. Bullish Divergence Signal (Trend Reversal)
A bullish RSI divergence occurs when RSI makes a higher low while price makes a lower low. The more times this occurs the more bullish the signal is believed to be. At times this lack of downside confirmation by RSI can signal that downside momentum is waning. The advantage offered to traders by this type of analysis is that it cannot be seen simply by looking at price action alone.
During an uptrend, there are two ways RSI signals a potential bearish price reversal upward.
1. Bearish Overbought Signal (Trend Reversal)
A bearish overbought signal occurs when the RSI rises to an overbought level (70% or more), and then declines below it, generating a signal that bearish sentiment may be gaining momentum.
2. Bearish Trend Alert (Trend Confirmation)
A bearish trend alert occurs when the RSI drops from above to below the neutral 50% level. This is more useful when using an RSI time period of 14 days or more than when using less than 14 days.
3. Bearish Divergence Signal: Trend Reversal
A bearish RSI divergence occurs when RSI makes a lower high while price makes a higher high. The more times this occurs the more bearish the signal is believed to be. At times this lack of upside confirmation by RSI can signal that upside momentum is waning. The advantage offered to traders by this type of analysis is that it cannot be seen simply by looking at price action alone.
The Relative Strength Index (RSI) can be useful in a variety of different ways. It can be used to confirm a new trend (with a move from below 50% to above 50%, or vice versa), to suggest when a given move may be getting overbought (above 70%) or oversold (below 30%) and also when a potential price reversal may be possible (bullish divergence or bearish divergence).