RSI: Relative Strength Index

Relative strength index (RSI)

The Relative Strength Index (RSI), developed by J. Welles Wilder, is a momentum oscillator which measures the speed and change in price movements.

The main purpose of this oscillator is to determine the overbought and oversold areas of the financial instrument studied, used to determine any trend changes through, not only the achievement of these areas, but also through the study of the divergences that occur between this oscillator comparing the prices of the chart.

RSI: construction

The RSI is presented as a single line, which moves on an abscissa representing the time period and an ordinate with scale values from 0 to 100, representing in absolute value the momentum in terms of speed and change in the prices of the instrument financial studied.

The standard set-up of this oscillator is set at 14 Periods and provides on the ordinate axis 3 very important verification lines placed at absolute values of 70, 50 and 30.

Traditionally, the RSI is considered to be overbought when it is above 70 and oversold when it is below 30, while the value set at 50 represents the median of the scale and often coincides with important support / resistance zones.

Graphical representation of RSI

RSI: how it works

RSI, as we have seen, is generally set at 14 periods with the oscillator line moving over time, marking the speed and change of price movements concerning the financial instrument studied, highlighting when there are limit situations of OVERBOUGHT or OVERSOLD .

Oversold levels typically occur below the 30 level, while overbought levels occur above the 70 value. The level lines should cut the highest peaks and the lowest troughs generating a signal at their intersection.

These traditional levels can also be adjusted if necessary to better suit the title. For example, if a stock repeatedly hits the overbought level of 70, you can improve the oscillator by adjusting this level to 80. The same goes for oversold zones where traders often use the value 20 instead of 30 for their chart.

Statistically, during an uptrend in a bull market, the RSI tends to remain in the 40-90 range with the 40-50 zone serving as support.  Conversely, in a bearish trend or bear market, the RSI tends to stay in the 10-60 range with the 50-60 zone serving as a resistance. These ranges will vary depending on the RSI settings and the strength of the underlying trend of the stock or market so it is always important to determine which is the best value to use in relation to the financial instrument being studied.

During strong trends, the RSI could remain in the overbought or oversold areas for long periods and continue to retest the same areas frequently.

Over-bought and over-sold areas identified through RSI

It is interesting to note that if the price of the financial instrument studied reaches a new high or low, but this is not confirmed by the RSI (ie it does not exceed the level considered to be the limit, in this case 70), this divergence can signal a price reversal.

Divergence between RSI and price action on the chart

RSI as a price target

RSI has many qualities, but among these there is no possibility of establishing a price target. The very simple reason is that it is based on a “momentum” of the price variation, so it is not focused on the value of the price, but on its dynamic of change over time.

Therefore, this oscillator does not allow to set price targets, but only to identify overbought and oversold zones that generate entry and exit signals at the break of these predetermined levels.

It should be noted that RSI used alone cannot guarantee reliable signals; this is the reason why it must always combine other indicators, such as the Bollinger Bands or the MACD to confirm the signals and from the graphical analysis to identify target prices.

Buy signals on oversold and sell signals on overbought

However, we must not be deceived by these signals for two simple reasons. The first is that having reached an overbought or oversold level does not mean that the price will reverse the trend immediately; if supported by a significant price momentum, it will remain in the overbought or oversold area for longer.

The second is because the only real certain signal that this oscillator provides is given through the research on the chart of the divergences between price and indicator. The significance of a divergence increases as the proximity to an extreme overbought or oversold zone increases.

In summary, RSI provides a BUY input signal when the breakout of the value 30 occurs which delimits and identifies the oversold zone; the achievement of this value indicates that the directional thrust of the descending trend is in the exhaustion phase. However, this signal is not sufficient to consider an entry valid at 100% that must be confirmed by the presence on the chart of a bullish divergence, or with the breakout of an important price resistance, or by applying a filter using a second indicator such as the WaveUP Indicator which can confirm the signals.

BUY confirmation on divergence between RSI and chart price action

For the SELL signals the breakout of the value 70 will establish the probability of exhaustion of the thrust of the ascending trend by entering an overbought zone.

Also in this case, it is necessary to confirm this signal with the same indications and with the filter and control tools mentioned for the BUY input situation.