The RSI Indicator (Relative Strength Index) is a price-following oscillator that ranges between 0 and 100. The RSI refers to the momentum oscillators, which measures the speed and magnitude of price changes. Momentum is the rate of the rise or fall in price.
Developed by Welles Wilder, the Relative Strength Index is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between 0 and 100. According to Wilder, the market is considered overbought when RSI rose above 70 and oversold when it falls below 30.
RSI is a highly popular momentum indicator that has been featured in many articles and books over the years. In particular, Constance Brown’s book, Technical Analysis for the Trading Professional, features the concept of bull market and bear market ranges for RSI. Andrew Cardwell, Brown’s RSI mentor, introduced positive and negative reversals for RSI. Also, Cardwell turned the notion of divergence, literally and figuratively, on its head.
J. Welles Wilder developed the Relative Strength Index indicator and published article about it in a 1978 book, New Concepts in Technical Trading Systems, and in Commodities magazine (now Futures magazine) in the June 1978 issue. It has become one of the most popular oscillator indices.
The main idea behind Wilders RSI Indicator was to normalize ratio between Average Gain and Average Loss for a particular number of periods N.
RSI = 100-(100/(1+U/D))
U = Sum of gains over past N periods;
D = Sum of Loss over past N periods;
N – number of periods;
Usage in trading
Through the years there are a lot of strategies and methods of using RSI Indicator. The most popular known, developed by W. Wilder are Tops and bottoms, patterns of the RSI indicator, False swings, Support and Resistance levels, Divergences…
Tops and bottoms
The Relative Strength Index usually has a pick near 70 and bottom below 30. It usually forms these extremums before the price chart, so it is possible to make a prediction about price turnaround on this basis.
The RSI often forms patterns such as head and shoulders or triangles that may or may not be visible on the price chart. Such formations considered as standalone trading signals, or, sometimes, as confirmation signals.
Here can be seen a Triangle formation, which indicates trend reversion. Head and shoulders also indicate reversion.
Failure swing formation considered when the Relative Strength Index tries to surpass a previous high (peak) or fall below a recent low (trough) but fail this attempt. Such behavior confirms reversion fo the price and can be considered as a trading signal.
We see confirmation of the trend reversion, reliable Sell signal.
Support and Resistance levels
It is common technique – to locate support/resistance levels not only on main price chart but also on RSI indicator chart. Similarly to chart levels, these levels are often used to spot price pivot points or even confirm levels and breakouts.
Divergence – discrepancies in the testimony of the indicator and prices. For instance, Divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the Relative Strength Index. Prices usually correct and move in the direction of the RSI.