« What is the Relative Strength Index (RSI) Technical Indicator? »

We utilize the relative strength indicator ubiquitously in our work, whether it be analysis of the stock markets in general, or analysis of individual stocks and ETFs. So, for the benefit of newcomers and technical analysis beginners, here's a refresher on RSI.

Introduction

The Relative Strength Index, which is generally referred to as "RSI" (so as not to be confused with the "Relative Strength" concept utilized in other arenas of investment management), is a creation of J. Welles Wilder and was introduced in his book titled "New Concepts in Technical Trading Systems".

RSI is a momentum oscillator that attempts to quantify the direction and strength of the recent trend in prices. While RSI is typically most effective when prices are trading within a horizontal range, the indicator is also capable of detecting extreme market conditions following a strong trend, as well as loss of momentum during ongoing trends.

Construction & Workings

The formula that is used to calculate RSI takes into account the number of points gained on up-days and those lost on down-days over the preceding 14-day period, and then plots the resultant value on a vertical scale of 0 to 100. It is important to note that it is not only the direction of trend that determines RSI readings but also the momentum - as measured by the amplitude of positive versus negative price changes - in the trend.

Overbought and oversold conditions in a stock, as per Relative Strength Index (RSI)

A rising trend that is gaining momentum will push the index towards 100, while a declining trend that is gaining momentum will push it towards 0. Whilst there are slightly more advanced interpretations of RSI (we'll look at the same shortly), perhaps the most utilitarian use of this momentum indicator is the concept of an overextended trend.

Overbought/Oversold Indications

As the chart above shows, stocks tend to take a breather when RSI reaches an extreme reading (typically above 70 or below 30). When RSI reaches one of these extremes, the ongoing trend in the stock is considered overextended and perhaps in need of a brief correction or consolidation, if not an all-out reversal. 

A stock that is overextended to the upside (showing an RSI reading above 70) is said to be overbought(because there has arguably been "too much" buying pressure in the stock), and a stock that is overextended to the downside (showing an RSI reading below 30) is said to be oversold (perhaps because there has been too much "selling pressure" of late).

Interpretations

Amongst the most commonly used intermediate level interpretations of the Relative Strength Index (RSI) are failure swings, divergences, centerline crossovers and chart formations.

Failure Swings

The concept of a failure swing is one of the building blocks of the entire body of technical analysis. As it pertains to RSI, a failure swing is said to occur when one of the following conditions is met:

a) Positive failure swing: RSI makes a short-term low below 30, and then rises slightly to form an intervening peak (preferably at a level not higher than 40-45, but under no circumstance higher than 50), before making another low at a level higher than the first low and thereafter rallying past the level of the intervening peak.

b) Negative failure swing: RSI makes a short-term high above 70, and then rises slightly to form an intervening trough (preferably at a level not lower than 55-60, but under no circumstance lower than 50), before making another high at a level lower than the first high and thereafter declining below the level of the intervening trough.

Positive and negative failure swings on Relative Strength Index (RSI)

Failure swing are also known as "W-formations," for obvious reasons. Positive failure swings are seen as weak to moderate buy signals (or at least as a reason to strongly consider closing short positions), while negative failure swings are seen as weak to moderate sell signals (or at least as a reason to strongly consider closing long positions). You'll notice how the signals generated in the case of SBUX and QLGC (above), respectively, proved to be foretelling.

Note that the course of price action does not matter when it comes to failure swings; as we'll see next, it does matter when it comes to divergences.

Divergences

According to Wilder, the divergence is "the single most indicative characteristic of the Relative Strength Index." The presence of a divergence usually indicates the weakening of a trend and often foretells a trend reversal.

A "divergence" is said to occur when a 'failure swing' occurs on RSI together with a 'non-failure swing' on price action. In other words, when price makes a lowerlow at the same time that RSI makes a higher low, a potential positive divergence or bullish divergence is said to occur. Also, when price makes a higher high at the same time that RSI make a lower high, a potential negative or bearish divergence is said to occur.

As mentioned earlier, the failure swing needs to occur near oversold (overbought) levels and the intervening peak (trough) should form a reasonable distance below (above) the centerline, in order for a reliable bullish (bearish) signal to occur.

Positive and negative divergences between price and Relative Strength Index (RSI)

AMLN (above left) experienced a strong downtrend into mid-Dec, which sent RSI deeply into oversold territory. The stock then made a minor turnaround (pushing RSI nearly as high as 40), only to resume its decline a week or so later and form a lower low. This time, however, RSI did not fall as far as its previous low. Price then quickly reversed course to complete a positive divergence with RSI and a new uptrend had begun.

BA (above right) was in the midst of a strong rally in late-Apr, when the stock encountered a small correction. The rally resumed within a week or so and the stock went on to make a new high. RSI did not make a higher high, however, and as such a potential negative divergence was left on the charts. The sell signal was confirmed and a new downtrend began shortly thereafter.

Centerline Crossovers

The RSI 50-line is often an important demarcation that either confirms a new trend or upholds an existing one. Simplistically, an RSI reading greater than 50 provides a bullish tilt on the security, while a reading less than 50 provides a bearish tilt. Beyond this basic interpretation, however, one can find confirmatory signals either in support of or against an existing trend.

When RSI has been trading below the centerline and then pushes above it, a positive centerline crossover is said to occur; such an occurrence is considered to provide confirmation of a bullish reversal. On the other hand, when RSI has been trading above the centerline and then moves beneath it, a negative centerline crossover is said to have taken place; this sort of occurrence is looked at as confirmation of a bearish reversal.

Positive and negative centerline crossovers on the Relative Strength Index (RSI)

This chart of NOV shows two negative centerline crossovers and one positive centerline crossover. The negative centerline crossover in September confirmed that a new downtrend was on the cards. This downtrend lasted until RSI bounced out of oversold territory and made a positive centerline crossover, which confirmed the new uptrend, in mid-October. A couple of attempts to move price lower in early- and mid- November were thwarted by a supportive RSI centerline and the uptrend continued until a negative divergence followed by a negative centerline crossover confirmed another negative turnaround in the first half of December.

Chart Formations

Interestingly, RSI sometimes forms common price patterns and trendlines that are not visible on contemporaneous price action. These chart formations can often prove to be very useful information to the trader.

Signals generated by chart formations on Relative Strength Index (RSI) itself

FDX (above left) was showing a potential head and shoulders bottom on RSI in early September. A trader who had taken the breakout signal shown on the chart, when the stock was trading at ~102, would have had an entry price $3-5 lower than a trader who waited for a breaking of the lateral price resistance line shown on the chart.

COP (above right) was in the midst of a strong uptrend in mid-Dec, when RSI showed the first signs of warning. A trader who entered a short position (or sold an existing long) on the breaking of the rising trendline on RSI would have enjoyed a profit that was larger by $6 than that attained by a trader who placed his bets on the rising trendline on price itself.

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So there you have it. RSI can be a very useful tool to a trader. We consider it one of the foremost methods of analysis of a stock. If you have any questions or comments about the indicator, please feel free to leave a comment below. Also do not forget to subscribe to the RSS feed of our stock market and trading blog, if you have not done so already