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What Is The Relative Strength Index (RSI)?

Views 8232022.08.03

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Key takeaways

  • The Relative Strength Index (RSI) is a momentum indicator that measures the speed and magnitude of price movements.

  • The RSI is generally considered overbought when above 70 and oversold when below 30.

  • RSI divergence and failure swings can also generate trading signals.

    Understanding the Relative Strength Index

    The Relative Strength Index (RSI), developed by J. Welles Wilder, is a momentum indicator to measure the magnitude of recent price changes to indicate whether a stock or other asset price is overbought or oversold. The formula for the RSI is

    https://courseimg.futunn.com/2022063000000296c0d416c2509.png

    where RS = Average Gain of n days up / Average Loss of n days down

    According to Welles (1978), the standard n is 14, but this can be lowered to increase sensitivity or raised to decrease sensitivity. The parameters also depend on the volatility of the security.

    How to interpret the RSI?

    Overbought and Oversold  

    In terms of market analysis and trading signals, it is considered a bullish indicator when the RSI moves above the 30 reference level. Conversely, when the RSI falls below the 70 reference level is regarded as a bearish signal. Since some assets are more volatile and move faster than others, values of 80 and 20 are also commonly used for overbought and oversold assets.

    https://courseimg.futunn.com/2022063000000297a8e13b08640.png

    (Images provided are not current and any securities are shown for illustrative purposes only.)

    Divergence

    Divergence is a term technical analysts use to describe price signals moving in the opposite direction of a technical indicator. A bullish divergence occurs when the price of a security reaches a lower low, and the RSI forms a higher low. The RSI has yet to confirm a lower low, which suggests building momentum.

    https://courseimg.futunn.com/20220630000002984dd985f912b.png

    (Images provided are not current and any securities are shown for illustrative purposes only.)

    A bearish divergence is identified when a security reaches a higher high, and the RSI forms a lower high. The RSI did not confirm new highs, suggesting that momentum is waning.

    https://courseimg.futunn.com/202206300000029922766bdd7a9.png

    (Images provided are not current and any securities are shown for illustrative purposes only.)

    Failure Swings

    Failure swings made by RSI signal a price reversal that is entirely independent of price and relies on RSI. Failure swings occur when the RSI does not follow the highs in an uptrend or the lows in a downtrend, considered to be either bearish or bullish failure.

    A bearish failure swing

    1. RSI rises above 70 and drops back below 70.

    2. RSI rises slightly but remains below 70.

    3. RSI drops lower than its previous low.

    https://courseimg.futunn.com/2022063000000300d09d67599a9.png

    (Images provided are not current and any securities are shown for illustrative purposes only.)

    A bullish failure swing

    1. RSI drops below 30 and rises back above 30.

    2. RSI retracts but remains above 30.

    3. RSI breaks out above its previous high.

    https://courseimg.futunn.com/2022063000000301310a98ae9d2.png

    (Images provided are not current and any securities are shown for illustrative purposes only.)

    Limitations of the RSI

    RSI is a useful momentum indicator that measures the magnitude of the price movement. However, here are a few limitations when using RSI.

    When the trend is strong, the RSI can become less accurate. While RSI may still provide some value in a strong trend, it should be used cautiously.

    RSI is not a good tool for confirming or executing trades. Most traders find the RSI most valuable as an initial indicator to identify trading opportunities and facilitate further research and evaluation. This is because the RSI does an excellent job identifying overbought or oversold conditions. Still, it does not provide strong evidence to determine whether these conditions reflect good trading opportunities.

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