Dolomite Learning Series: Relative Strength Index
Figure 1 — RSI — Source: investorsunderground.com
What Is the Relative Strength Index?
The Relative Strength Index (RSI) is an extremely useful indicator that is used to signal oversold or overbought conditions in a tradable asset. The RSI is displayed as a line graph that moves between two extremes and has a reading from 0 to 100. In general, readings over 70 are considered overbought and readings under 30 are considered underbought (see Figure 1).
This indicator was originally developed by J. Welles Wilder Jr. He introduced RSI along with several other indicators in his 1978 book, “New Concepts In Technical Trading Systems”.The Relative Strength Index is a momentum oscillator that can be used in conjunction with other indicators to indicate a general trend or divergence.
Figure 2 — Relative Strength Index Formula — Source: stockcharts.com
J. Welles Wilder Jr. developed this formula (see Figure 2) before the computer age and it still remains a reliable tool for many traders today.
Figure 3 — McDonalds Stock Analyzed Using RSI — Source: stockcharts.com
RSI Divergences
According to Merriam-Webster, a divergence is defined as “a deviation from a course or standard”. RSI Divergences can sometimes signal a trend reversal. A bullish divergence occurs when the tradable asset’s price forms a lower low and the RSI forms a higher low. This generally signals an increase in bullish momentum due to the RSI not confirming the lower low.
Figures 4 and 5 — Bullish And Bearish Diversion — Source: Forextips.com
A bearish divergence occurs when the tradable asset’s price forms a higher high but the RSI forms a lower high. This generally signals weakening bullish momentum due to the RSI not confirming the new high.
Cautious Trading = More Informed Decisions
The general trend must be considered when analyzing RSI. For example, the RSI can remain in oversold territory for an extended period of time during a downtrend. The indicator can also remain in overbought territory for extended periods during uptrends. Due to this, traders must be cautious when utilizing the Relative Strength Index.
As with all individual indicators, RSI alone should not be used to make trading decisions. The more indicators that agree with each other creates a greater chance of making an informed trading decision. The choice of indicators is up to the personal preference of the trader. However, RSI is an extremely popular indicator and gives traders a better understanding of momentum and market sentiment.
Thank you for reading this installment of the Dolomite Learning Series. Next week I will be discussing moving averages. Happy Trading!
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Disclaimer: The information here is intended to be used for educational purposes only and is not financial advice. I am not a financial adviser.
