The RSI Indicator is a popular indicator used by traders and investors to help identify changes in momentum of a stock or the market. Known as the Relative Strength Index, the RSI was developed by J. Welles Wilder in 1978 to measure the relative strength of price currently compared to its price history over a set number of periods. The RSI indicator is useful in several ways to help identify when to buy and when to sell. It is best when used in conjunction with other indicators such as the MACD and the Slow Stochastic.
Relative Strength Indicator Explained
An explanation of the Relative Strength Indicator is easy to understand. The RSI indicator is plotted on a panel above or below the price chart. It is easy to identify the set-up as the RSI indicator shows the market’s strength compared to the historical price trend. The shorter the time period used for the RSI calculation, the more volatile the RSI’s movements. The typical period is 14, though it can be easily adjusted using stock charting programs. Other values that are used are 9, 11, and 25 periods.
The RSI indicator is similar to the Money flow Index (MFI) in how you interrupt the signals and in how it is calculated. The MFI is volume weighted. Including volume should make the MFI a better indicator, as volume is an important factor in rising stock prices. To rise, the market needs volume at or above the average. Buyers are what drive prices higher. When the market goes down, it can be caused by above average selling volume. This is why the MFI includes volume in its calculation.
However, the market can go down on low volume. On days when there are no buyers and only a few sellers, the market goes down with below average volume. These days cause the MFI to misrepresent the meaning of the indicator. Since it is volume weighted. It turns out that there quite a few number of down days with below average volume. As a result, the MFI indicator tends to skew the result for those days. Since the RSI indicator does not include volume in its calculation, it is not affected by this problem. Therefore, I selected the RSI over the MFI as the better indicator.
For those who wish to understand the RSI calculation please see the end of this article.
Overbought Oversold Indicator
As a measure of overbought and oversold conditions, the RSI indicator provides investors a way to identify a security or index that is reversing direction. When RSI is above 70, it is signaling an overbought condition, indicating an investor needs to be ready to close their long positions or establish downside protection. As the RSI turns down through 70, it is giving a sell signal.
An RSI below 30 indicates an oversold condition, acting as a warning to the investor to be ready to buy the best set ups. As the RSI indicator rises through 30, it gives a buy signal. This is especially true if the long-term trend is up, as the RSI rises through 30, creating potential entry points.
The 20-year monthly chart of the S&P 500 offers an interesting example of the RSI indicator. In this chart, there are five instances where the RSI (14) gave sell signals when it fell through 70. In one case, there was a false signal as the market rebounded.
In two cases, the RSI indicator was below and turned up through 30, it gave a buy signal. The first of these signals was a good time to buy. In the second case, we do not yet know if the buy will work.
The RSI overbought oversold condition works to make an investor aware that such a situation is in place. However, it tends to give false signals, especially in shorter time frames. At Trading Online Markets, we occasionally employ this feature of the RSI, though we recognize that the signal can be early or give false readings.
A divergence occurs when the indicator’s trend goes in the opposite direction of the price trend. Positive divergences should begin with a trough below 30 and negative divergences should begin with a peak above 70. A positive RSI divergence takes place when the RSI starts to trend up and the price is continues to trend down or move sideways. The price might be making new lows or testing the lows, yet the RSI is rising indicating the downtrend is slowing and about to turn up. Investors should consider this situation as a buy signal. Remember the RSI the first trough of the positive divergence must be below 30
When the price is making new highs or testing the recent high but the RSI has already turned down from its previous high we have a negative divergence on the RSI. This indicates the up trend is beginning to falter and is more likely to turn down. In this case, investors should consider this a sell signal. Keep in mind the first peak of the negative divergence must be above 70.
Using the same 20-year monthly S&P 500 chart there are three divergences on the chart, two negative and one positive. In each case, the divergence gave a good signal as the market reversed course and started a new trend. As of May 1, 2009, the RSI has not provided a positive divergence signal. We have the first trough below 30 in place. We now need to see another trough that is higher than the last one to see positive divergence.
The RSI divergence signal works well in all time frames. We use it in our analysis of the charts, especially for the Premium Members.
The RSI Indicator has a centerline at 50. The 50 centerline indicates a transition from a bear to a bull market if it is rising and from a bull to a bear market if it is falling. We use this signal to help identify such transitions, as it seems to work quite well, especially in longer time frames. Occasionally, we will adjust the period of the chart to improve the value of the signal that it offers.
In the same 20-year month S&P 500 chart there are two bear market signals and one bull market signal. In each case, the signal was accurate as the market moved significantly in the direction as indicated. The RSI crossover tends to be a lagging signal in some cases, though it also seems to have very few false signs. This makes the RSI crossover a valued tool when used in conjunction with other market trending indicators.
Application of the RSI Indicator
At Trading Online Markets, we use the RSI indicator as a sign of a change in the trend and as a buy or sell signal. All three features (overbought oversold, divergence, and crossover) of the RSI provide quality signals of a change in the trend.
It is always a good idea to employ other indicators to compliment the signals given by the RSI indicator. At Trading Online Markets LLC and Peregrine Advisors LLC. we also employ several technical indicators including the MACD and the Slow Stochastic. In addition, we might include other technical indicators when conditions warrant.
Assuming the period for the RSI calculation is 14 then the calculation is performed as follows:
Average Loss = ((previous average loss) x 13 – current loss) / 14
First Average Loss = total of Losses during pas 14 period / 14
Average Gain = ((previous average gain) x 13 + current gain) / 14
First average gain – total of gains during pas 14 periods / 14
RS = Average Gain / Average Loss
RSI = 100 – (100/(1 + RS))
If you wish to learn more on how to use technical analysis, I encourage you to try our four-week free trial subscription to our Premium Pages. There is no risk and no obligation.