A popular oscillator that compares a trading instrumentals magnitude of recent gains against losses to reflect the momentum of the market.
Overview
Developed by J. Wells Wilder and introduced in his 1978 book, “New Concepts in Technical Trading Systems”, the Relative Strength Index (RSI) has become a very popular oscillator and useful momentum oscillator. The RSI compares a trading instrument’s magnitude of recent gains against its magnitude of recent losses and quantifies this information into a value that ranges between 0 and 100.
Often times the name “Relative Strength Index” is slightly confusing or misleading because the RSI does not compare the relative strength of two trading instruments, but rather the internal strength of a single trading instrument. A more appropriate name might have been “Internal Strength Index”, but most traders simply refer to it as “the RSI” in an effort not to confuse it with John Murphy’s “Relative Strength” charts and IBD’s “Relative Strength” rankings.
The RSI plotted on the AUD/NZD Daily Chart 4/3/2011
Source: VT Trader
Interpretation
There are several popular methods of analyzing the RSI, some of which include:
Overbought/Oversold Conditions: The RSI can be used to identify potential overbought and oversold conditions in price movements. An Overbought condition is generally described as the RSI being greater than or equal to the 70% level while an oversold condition is generally described as the RSI being less than or equal to the 30% level. Trades can be generated when the RSI crosses these levels. When the RSI crosses above 30 a buy signal is given. Alternatively, when the RSI crosses below 70 a sell signal is given.
Divergence: Looking for divergences between the RSI and price can prove to be very effective in identifying potential reversal points in price movement. Trade long on Classic Bullish Divergence: Lower lows in price and higher lows in the RSI; Trade short on Classic Bearish Divergence: Higher highs in price and lower highs in the RSI. These types of divergence are often indications of an impending reversal.
Support /Resistance and “Failure Swings”: The RSI shows, sometimes more clearly than price itself, levels of support and resistance. Failure swings (a.k.a. support/resistance breakouts) occur when the RSI surpasses a previous high (peak) or falls below a recent low (trough). Advanced applications of the RSI uses 40 as support during up-trends and 60 as resistance in down-trends.
RSI / 50-level Crossover: When the RSI crosses above 50 a buy signal is given. Alternatively, when the RSI crosses below 50 a sell signal is given.
Chart Formations: The RSI often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart.
