THE RELATIVE STRENGTH INDICATOR
By Daryl Guppy
indicators are constructed by manipulating some aspect of price such as a
moving average of prices over a 10 day period. The Relative Strength
Indicator (RSI) tries to anticipate a change in the trend. This is a leading
indicator of a trend change. The results are used to deliver messages about
the strength of the market. It is called an oscillator because the indicator
readings are converted into percentage results which range from 0% to 100%.
The position of each day’s indicator reading gives the trader an indication
of the strength, or weakness, of the existing price trend.
The RSI is calculated by monitoring changes in the closing prices of the
stock. The number of higher closes is compared to the number of lower closes
for the selected period. The RSI compares the internal strength of a stock
by looking at the average of the upwards price changes and comparing it with
the average of the downward price changes. The results are expressed as a
percentage, providing the upper and lower boundaries. The plotted results
oscillate between these two levels and give traders information about the
speed and acceleration of the changes. Traders use either a 14, 9, or 7 day
period in the Relative Strength Calculation.
In this sense the RSI is very similar to a stochastic and uses similar
principles. Where the stochastic quantifies the ability of the market to
close near the high or the low of the day, the RSI quantifies the strength
of the way the market moves higher, or lower. The over-bought and over-sold
signals are the same as any oscillator, although with an RSI they are
traditionally set at 70% and 30%.
The most significant trading signal delivered by any oscillator style
indicator is a divergence signal. This sounds complicated but it just means
that the significant valley patterns shown by the RSI trend in the opposite
direction to the significant valley patterns as shown by the price line
chart. A valley is created by two distinct lows that each precede a rally
from a downtrend. This builds a valley in the price chart. The lows of these
valleys are joined with a short trend line as shown.
The corresponding lows on the RSI indicator are also joined by a short trend
line. When the RSI line slopes differently from the price chart line, a
divergence occurs. When these valleys form below the 30% area on the RSI, or
form peaks above the 70% level, they are most reliable. Oscillator activity
between these levels is not used to find divergence signals.
signals give the trader an advantage by confirming an entry into a downtrend
as it weakens and just before it turns into an up trend. It is also used to
get out of an up trend as it weakens, and before it collapses into a
downtrend. The divergence signal does not occur every time a trend changes,
but when it does, it delivers a strong confirmation signal that a trend
break is likely.
RSI divergence signals often appear in advance of a trend change, but they
are not very good at suggesting the time of a trend change. The divergence
signal may appear just as the trend changes, as in the chart extract, or
several weeks before. Traders use the RSI divergence as an early warning
signal to enable them to prepare for a trend change.
When the RSI and price chart lines move in the same way we get a confirming
signal that the existing price trend is unlikely to change. These signals
are not very important because we can get the same information from just
looking at the chart.
The RSI is one of the very few oscillator style indicators where trend lines
and support and resistance lines can be effectively used. These are used as
signals to confirm the trend shown on the price chart. When other chart
patterns suggest action, then the RSI trend line might also confirm this.
When the RSI is used like this it does not give the trader any distinct
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