The Relative Strength Index (RSI) is a widely used momentum indicator in technical analysis that helps traders evaluate overbought or oversold conditions in the price of a security. Developed by J. Welles Wilder Jr. and introduced in 1978, the RSI measures the speed and magnitude of recent price changes to provide insights into the strength and direction of a security’s price movements.
The RSI is displayed as an oscillator on a scale of zero to 100, providing a graphical representation of the indicator. It is commonly plotted beneath the price chart of a security. A reading above 70 is traditionally considered overbought, indicating a possible price reversal or corrective pullback, while a reading below 30 suggests an oversold condition, potentially signaling a price recovery.
The RSI calculation involves comparing the strength of price gains to price losses over a specific period, often 14 periods. The formula uses average gains and losses, taking into account the positive value of the average loss. Initially, the RSI calculation involves determining the average percentage gain and loss during the look-back period.
To effectively use the RSI in conjunction with trends, traders need to consider the primary trend of the security. Oversold and overbought readings differ depending on whether the security is in an uptrend or a downtrend. Adjusting the RSI levels according to the prevailing trend helps traders interpret signals accurately.
Examples of RSI Divergences and Reversals: RSI divergences occur when the price moves in the opposite direction of the RSI, potentially indicating a change in momentum before a corresponding change in price. Bullish divergences occur when the RSI shows oversold conditions followed by higher lows, while bearish divergences involve overbought conditions and lower highs.
Positive and negative RSI reversals occur when the RSI reaches extreme levels and the price makes higher or lower highs. These reversals can serve as buy or sell signals, depending on the direction of the RSI and price movements.
Additionally, traders can observe swing rejections in the RSI when it emerges from overbought or oversold territory, indicating potential trend reversals.
Comparing RSI and MACD: While both the RSI and the Moving Average Convergence Divergence (MACD) are momentum indicators, they differ in their calculation methods and the insights they provide. The RSI measures the price momentum by comparing gains and losses, while the MACD focuses on the relationship between two moving averages. Traders often use these indicators together to gain a comprehensive understanding of market conditions.
Limitations of the RSI: Traders should be aware of the limitations of the RSI. False signals can occur, and it may stay in overbought or oversold territory for extended periods during strong trending markets. The reliability of the RSI is highest in oscillating markets where prices alternate between bullish and bearish movements.