The Relative Strength Index is a momentum indicator used in technical analysis. It measures the speed and change of price movements to evaluate overbought or oversold conditions. The RSI oscillates between the value of 0 and 100. The developer, J. Welles Wilder, came up with the concept and wrote it in his 1978 book, “New Concepts in Technical Trading Systems.”
How this Indicator Works
When the RSI indicator value is above 70, it is said to be overbought. On the other hand, when it is below 30, it is said to be oversold.
When there is a bull market, the RSI maintains a 40 to 90 range within the 40-50 zone, acting as support. On the other hand, a bear market will be characterized with a 10 to 60 range with a 50-60 zone acting as resistance. The mentioned ranges might vary based on the RSI settings. The other factor for variation may also be the strength of the markets’ trend or security.
An underlying price high or low that the RSI does not confirm indicates a price reversal. A Top Swing Failure occurs when the RSI makes a lower high and moves below a previous low. A Bottom Swing Failure occurs when the RSI makes a higher low and follows an upward move above the previous high.
The RSI could also create chart patterns that may not necessarily be visible on the chart. Such include double tops and bottoms and trend lines. One can also derive support and resistance from the chart.
To calculate the RSI, refer to Wilder’s book for more information. It is a relatively simple formula, but it isn’t easy to explain without examples. However, note that averaging price gains and losses calculate RSI over a given period. The default time period is 14 periods, with values ranging from 0 to 100. The basic formula is:
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]