Relative Strength Index (RSI)
Indicator Type: Counter Trend
Introduction:
The RSI was developed by J. Welles Wilder, Jr. as a measure of the market’s
strength or weakness. The principle idea of this study is that it will indicate
a general zone that the market is in, either the buy or sell zone. This
indicator is similar to Stochastics in that it shows regions of overbought and
oversold. This indicator should be incorporated into a system rather using it by
itself. Wilder’s popular indicator is known for its accuracy and its ability to
compensate for erratic price movement.
Interpretation:
RSI computes the difference in recent prices as a solid line and plots this line
on a scale similar to the one used by Stochastics. The area above 70 is
generally considered to be the overbought region, and the region below 30 is
referred to as the oversold region. Simply selling in the overbought region and
buying when RSI is in the oversold region is not a consistent method of trade.
Trade signals are not generated until the RSI leaves these regions. So a sell
signal would not be present until the RSI has begun sloping down and leaves the
70 region.
A buy signal, in the simple methodology associated with this pattern, is derived
when RSI leaves the oversold region – crosses from below 30 to above it. Just
like sell signals, RSI buy signals are present when the market begins to turn
and the indicator leaves the oversold region.
Another use of the RSI is to look for a divergence in prices. When a market
makes higher highs or lower lows and the RSI fails to follow suit. This
difference in the indicator and the market could be a signal that the market
lacks the momentum to continue its current price direction. So you may be able
to take a position sooner using this strategy than you would with the previous
way. Wilder says that this divergence is “the single most indicative
characteristic of the RSI.”
