Section: 3 Market Structure
Sub Section: 3 Relative Strength Index (RSI)
Relative Strength Index (RSI): The Relative Strength Index is a momentum oscillator that compares upward movements of the Close price with downward movements, and results in values that range from 0 to 100. The Relative Strength index was developed by J. Welles Wilder.
Overbought/Oversold: Wilder recommended using 70 and 30 and overbought and oversold levels respectively.Overbought: is a condition where the security appears to be over valued and may reverse in trend. Oversold: is a condition where the security appears to be under valued and may reverse in trend Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal.
Divergences: Buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and the underlying stock. For example, consider a falling stock whose RSI rises from a low point of (for example) 15 back up to say, 55. Because of how the RSI is constructed, the underlying stock will often reverse its direction soon after such a divergence. As in that example, divergences that occur after an overbought or oversold reading usually provide more reliable signals.
Centerline Crossover: The centerline for RSI is 50. Readings above and below can give the indicator a bullish or bearish tilt. On the whole, a reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning the battle. Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.
An example is illustrated graphically as follows: