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The RSI is presented in a graph below the price chart of a market. It is usually plotted as
lines along with two moving averages connecting the relevant values for each period.
Wilder recommended a smoothing period of 14. This is by his reckoning of EMA
smoothing, i.e. α=1/14 or N=27.
Wilder posited that when price moves up very rapidly, at some point it is considered
overbought. Likewise, when price falls very rapidly, at some point it is considered
oversold. In either case, Wilder felt a reaction or reversal is imminent. The slope of the
RSI is directly proportional to the velocity of the move. The distance traveled by the RSI
is proportional to the magnitude of the move.
As a result, Wilder believed that tops and bottoms are indicated when RSI goes above 70
or drops below 30. Traditionally, RSI readings greater than the 70 level are considered to
be in overbought territory, and RSI readings lower than the 30 level are considered to be
in oversold territory. In between the 30 and 70 level is considered neutral.
Wilder further believed that divergence between RSI and price action is a very strong
indication that a market turning point is imminent. Bearish divergence occurs when price
makes a new high but the RSI makes a lower high, thus failing to confirm. Bullish
divergence occurs when price makes a new low but RSI makes a higher low.
Wilder thought that "failure swings" above 70 and below 30 on the RSI are strong
indications of market reversals. For example, assume the RSI hits 76, pulls back to 72,
then rises to 77. If it falls below 72, Wilder would consider this a "failure swing" above
70.
Finally, Wilder wrote that chart formations and areas of support and resistance could
sometimes be more easily seen on the RSI chart as opposed to the price chart. The center
line for the relative strength index is 50, which is often seen as both the support and
resistance line for the indicator.
If the relative strength index is below 50, it generally means that the stock's losses are
greater than the gains. When the relative strength index is above 50, it generally means
that the gains are greater than the losses.
This is like the initial data point calculation shown above, but used on every day, not just
the first. The divisor N in the SMAs in the numerator and denominator cancel out, so one
needn't do those divisions, instead just a sum of U and a sum of D over the past N days
can be made.
Cutler's RSI generally comes out slightly different from the normal Wilder RSI, but the
two are similar, since SMA and EMA are similar.
The Relative Strength Index (RSI) compares the strength of a stock's recent gains to the
weakness of its recent losses and turns that information into a number that ranges from 0
to 100. The Relative Strength Index compares upward movements in closing price to
downward movements over a selected period. This could be used for short cycles and for
21 or 25 days for the intermediate cycle. Relative Strength Index is smoother than the
Momentum or Rate of Change oscillators and is not as susceptible to distortion from
unusually high or low prices at the start of the window. It is also formulated to fluctuate
between 0 and 100, enabling fixed Overbought and Oversold levels. The term "Relative
Strength Index" appears to be slightly misleading as the RSI only figures out the internal
strength of a single security, but does not compare the strength of two securities on any
such parameters discussed.
The Relative Strength Index (RSI) is a financial technical analysis oscillator showing
price strength by comparing upward and downward close-to-close movements. The RSI
is popular because it is relatively easy to interpret. It is calculated using the following
formula:
RSI= 100-100/1+RS.
RS= Average of x day’s up closes/ Average of x day’s down closes.
An asset or stock is deemed to be overbought once the RSI approaches the 70 level,
meaning that it may be getting overvalued and is a good candidate for testing fresh
resistance levels. Conversely, if the RSI approaches 30, it is an indication that the asset/
stock may be getting oversold and therefore likely to become undervalued.
References
1. Relative Strength, Comparative at MarketScreen.com
2. Cutler's RSI page at Aspen Graphics Technical Analysis Software
3. New Concepts in Technical Trading Systems by J. Welles Wilder,