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he Relative Strength Index, or RSI, is a momentum based oscillator. Not to be confused with the
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The relative strength index is calculated by taking the sum total of gains for a 14-day period and dividing it by the sum total of losses for the same 14-day period. The formula looks like this...
In order to create an oscillator that moves between 0 and 100, the following formula is applied...
There are many ways to interpret the relative strength index.
First, it can be used as an over-bought/over-sold indicator. Wilder used 70 and 30 to mark these levels.
If the indicator rises to 70, then turns down, it is considered a bearish sign. Conversely, if the indicator moves to below 30 and then turns up, it is taken as a bullish sign.
Additionally, the crossing of the 50 line may confirm a trend change. However, experience shows if the RSI oscillates between 80 and 40 the stock is in a bullish mode. If it bounces between 60 and 20... it's bearish.
"How is the Relative Strength Index applied?"
A powerful way to use the relative strength index is by letting it signal possible price reversals. This is done by identifying areas where the price of the stock diverges from the value of the RSI.
There are four types of divergences: bullish, bearish, positive and negative. At first, this may sound redundant... but, the latter two have some predictive value and are best explained through chart examples.
Taking a closer look, bullish and bearish RSI divergences are very common. The following illustration shows how they work...
Author and trader, Andrew Cardwell discovered two other types of divergences which he called positive and negative. These divergences are found in every phase of a stock's movement... whether it's trending or range bound.
The beauty of positive and negative divergences is their ability to forecast price movement.
First, locate positive and negative reversal patterns in the RSI and label the troughs and peeks like this...
Using the corresponding closing prices, plug them into the following formula to get the new up-side price target...
A down-side price target can be calculated using the negative reversal pattern. Label the peeks and trough on the RSI. Then, using the closing price, calculate the price objective with this formula...
Finally, the relative strength index can be used to identify whether a stock is trending or is trading in congestion. By applying moving averages to the RSI and the stock's price, you can determine the likely movement of the stock.
In the following chart, a 9-period simple moving average and a 45-period exponential moving average have been applied to both the price and the RSI of the stock.
Use these rules to determine whether the stock is trending or is in congestion...
IF: Price 9-SMA > Price 45-EMA AND RSI 9-SMA > RSI 45-EMA
THEN: Trend is up.
IF: Price 9-SMA < Price 45-EMA AND RSI 9-SMA < RSI 45-EMA
THEN: Trend is down.
IF: Price 9-SMA > Price 45-EMA AND RSI 9-SMA < RSI 45-EMA
THEN: Trend is sideways to up.
IF: Price 9-SMA < Price 45-EMA AND RSI 9-SMA > RSI 45-EMA
THEN: Trend is sideways to down.
The Relative Strength Index is a simple, yet powerful indicator that should be consulted prior to trading. For a more comprehensive look at the RSI, purchase the following books...
New Concepts in Technical Trading Systems
by Welles Wilder, Jr.
Trend Research
1978
140 Pages
Get This Book, Now!
Technical Analysis for the Trading Professional - Strategies and Techniques for Today's Turbulent Financial Markets
by Constance Brown
McGraw-Hill
1999
341 Pages
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