Most of the charts in my daily blog include this technical indicator and yet I feel it’s never been properly introduced. Today I aim to put that right.

Explanation
The RSI (Relative Strength Indicator) comes from the Oscillator family; developed by J. Welles Wilder it shows up overbought and oversold conditions in a market.

There’s something we need to get straight about the RSI right away. The ‘relative strength’ bit isn’t a comparison to any other market; it’s comparing the price of a security to its past performance. It’s a bit like my favourite rugby training when you’re told it doesn’t matter about beating the county winger, you only have to do better than your own previous score.

The RSI comes in an easy-to-use constant 0-100 range for comparison to other prices and has three key numbers, 30, 50 and 70. Unsurprisingly 50 is the mid-point where levels above 50 imply that momentum is with the buyers; below 50 favours the sellers. A value above 70 represents an overbought market; below 30 is an oversold market.

The default values for overbought/sold are 70/30, but some traders prefer the more cautious settings of 75/25 and even 80/20. Whilst some rely on 80/20 as their norm, others use the default settings, but flex to the more extreme 80/20 in the instance of a strong bull/ bear market.

Geek Corner
Hey, don’t worry; I’m not going to get Albert Einstein here. It’s just that some people like to look under the bonnet before they buy the car.

Wilder wanted to design an oscillator that used constant boundaries to enable comparison, but that didn’t get screwed up by erratic movements. The simple calculation is:

RSI = 100 – (100 / 1+RS)

Where RS = average of x days’ up closes/ average of x days’ down closes

To find the average up value add the total points gained on up days during the x period and divide it by x (I’m sure you can guess how to work out the down values). The default number of days used by wilder is 14, but as with so much of TA feel free to experiment and customise your own charts. Note: The shorter the time period used the more sensitive the oscillator becomes and the levels will swing around like a chimp’s testicles.

Where To Find The RSI
This is an easy one. On your chart, click on the settings box in the bottom left-hand corner. This will bring up the menu where you’ll find the RSI somewhere in the middle.

How Do We Use It?

(1) As Confirmation Of Another Indicator
The degree to which we use the RSI depends on what we’re looking for. A couple of my strategies are based on moving average crossovers and rely on the RSI solely as a confirmation (a number higher than 50 if I’m looking to buy; a number lower than 50 if I’m looking to sell).

Here, I’m not trying to call an overbought/oversold turn in the price; I’m looking for enough momentum already in the price to keep the trade running. I’m hoping to catch the 52-70ish part of the RSI range (48-30ish when shorting).

(2) Amber Warning Light
This is an extension of the trade I’ve just entered above. If I’m now running long of the market, I’ll keep one eye on the RSI level. If it starts to slide back below 50 that can be a warning that enthusiasm for the long trade is waning. I don’t treat this as a sell signal, but it usually gets me watching the chart more closely. Likewise, if the RSI pushes up above 70 I won’t sell immediately, but I’ll be alert to any failure to hit a new high and will be looking for reasons to either take profits or tighten my trailing stop loss. The thing is, 70 signals the entrance to the overbought range but there’s still plenty of scope for prices to become more overbought (as many a singed bear will tell you). All of this applies in reverse for short trades.

Equally, if I’m looking at a buy trade I’ll hold off if the RSI is above 70 (in overbought territory); I won’t sell if the RSI is already below 30.

(3) Limit Target
I don’t use this one myself, but I’ve seen trading strategies where the trader will close half of the trade when the RSI moves into overbought/sold territory. They’ll then use a different method (parabolic/ MAV crossover) to close the second part of the trade.

(4) Divergence Reversal Warning
In many ways this should be top billing; its originator, Mr Wilder, reckoned it was the “single most indicative characteristic of the relative strength indicator.”

Think of watching the 30/70 levels (as above) as beginners level and watching for divergence plays as more advanced analysis. This recognises that the levels can continue to rise well above 70 (below 30) so it’s far too early/ risky to call a reversal trade. Even as the RSI subsides, the finger stays well away from the trigger. The key here is to see if the next rise fails to reach the level achieved the first time around. This failure is then confirmed when the RSI breaks below the previous low.

The textbook divergence signal takes place in the 30/70 area while the price is still hitting fresh highs/lows. This acts as a strong warning to close out a winning trade and/ or to prepare for a reversal trade. This strategy is favoured by Zebu, who gave a great account of how he uses it in Profitable Mechanical Trading Systems.

Some traders will also add trend lines to the RSI chart, using a break in the trend as another early warning.

Trading Example

This chart of the Dow is a good example of ‘one we made earlier’ and one that is still in play. Check out the collapse in February; it would have been a painful experience going long the market when the RSI first went into oversold territory (A). And although point (B) is even more oversold, the pattern hasn’t indicated a buy trade. Patience Grasshopper. Finally, point (C) hits the button; the next fall in the RSI doesn’t hit the previous lows and subsequently breaks above the recent high. You can see how well this calls the turn in the market (I wish I’d paid attention at the time!).

Now, sprinting across to July you can see the opposite pattern still in play. The price continued to rally after the first venture into overbought territory (A) and looks to be flattening out at point (B). But here the market is still waiting for a point (C); it needs evidence of a failure to match the last overbought level, followed by a drop below the last low point.

Conclusion
So there you have it. The RSI is a team player; it’s happy to work in the advance party looking for new trades, or play the support role confirming possible sightings. It can be used as an indicator of extreme conditions, a trend reversal indicator, or to signal a build up (or loss) of momentum. Why not give it a try and see if it adds anything to your current strategy.