Relative Strength Index actually is not relative at all – it is an oscillator meant for the comparison of buying strength to the price or value of a security. Usually abbreviated by RSI, the relative strength index has been in use since its creation in 1978 by J. Welles Wilder. His name is commonly used to describe the RSI as default settings, “Wilder RSI,” which usually refers to a simple 14 period calculation unadulterated by different charting or time settings. Wilder RSI is the settings or preferences that Wilder used when studying price levels of different stocks and commodities.
RSI is used to determine the difference between the rising bars and falling bars. Through a series of mathematical functions, the RSI tells which has been stronger: buyers or sellers.
How RSI works
The relative strength index operates on a scale from 1 to 100. An RSI figure of less than 30 is considered oversold, and thus, a strong investment. Figures greater than 70 suggest that a stock is overbought, which usually comes before a correction. Some traders use figures such as 35 and 65, or 20 and 80. Regardless of the numbers used, the index generally operates like any other oscillator. The RSI generally moves up and down with price movements; however, when the index diverges from the price, a reversal is soon to follow.
What is divergence?
RSI divergence occurs when the price of a stock hits higher and higher peaks, while the RSI figure tapers off to smaller bumps. Higher prices, combined with weakening strength, indicate that a larger correction is on its way. When the price is soaring high and the strengths behind the investment are falling, the correction will always be exaggerated.
Divergence may also occur when a stock makes two or more bottoms that are trending downward, while the RSI hits higher and higher levels. This is usually a sign that a reversal is around the corner, and an upward breakout will follow the lead of the RSI. Low price, but advancing RSI, means that buying pressure is increasing, adding strength to the price.
Other ways to use RSI
There are other forms of Relative Strength Index that traders can utilize. Cutler’s RSI, as it is widely known, is a formula created to use the same concept of rising prices and rising indicator – but rather than the use of an exponential moving average, Cutler’s RSI uses a simple moving average.
Other variances include changing the time table in the RSI. A smoothing of 14 is optimal and suggested by Wilder for use on most securities. Altering the smoothing to a lower number produces a more volatile oscillator, mostly due to the drop in time in the average. Boosting the RSI to a figure of 25 is common, but will show only the most violent of market swings, a setting that can be used for prudent investors. After 14, figures of 9 and 25 are the most commonly used timetables.
The oscillator can also be used to show trending. Technical trend lines can be employed similar to how they are used on the price itself. An uptrend in the RSI is usually due to an increase in the market price and will trend with the price.
Combining RSI with other indicators
Relative Strength Index is an indicator, not an end all solution. Because it is an oscillator, and by nature delayed to market activity, it can be difficult to pick highs and lows. The most appropriate way to use the RSI is to compare current levels to past price movements. If XYZ stock moved up 3 points after touching 25 RSI, it would be rational to assume that the stock will repeat history.
Relative strength index is a great complement to any trader. The RSI is best mixed with other technical studies, such as moving averages and your own trend lines, which should make calling tops and bottoms a bit easier.