Overbought or Oversold? Find out using the Relative Strength Index (RSI)

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The Relative Strength Index (RSI) was developed in 1978 by J. Welles Wilder Jr. and featured in his book, “New Concepts in Trading Systems Techniques.” Wilder was initially an engineer and investor before entering market research.

The Relative Strength Index is one of the numerous technical indicators developed by Wilder, including Parabolic SAR, Average True Range (ATR), and Average Directional Movement Index (ADX). These indicators are still widely used and are often included by default in technical analysis and charting software.

Relative Strength Index Basics

The relative Strength Index is one of a collection of technical indicators known as Momentum Oscillators. A Momentum Oscillator measures the amount that price has changed over a given period, including the Moving Average Convergence Divergence (MACD) and the Stochastic Oscillator.

The Relative Strength Index is a useful indicator for determining when prices are overbought or oversold, but traders are always advised to use more than one indicator when making decisions.

RSI measures the speed and magnitude of the directional price change and represents the data on a chart by oscillating between 0 and 100. The data presented on the chart is calculated using the average gains and losses of a currency pair, commodity, or asset during a specific period of time. The default retracement setting for the indicator suggested by Wilder is 14 periods.

Lowering the default setting increases the indicator’s sensitivity, creating more instances of overbought and oversold conditions. Increasing the setting decreases sensitivity, causing fewer overbought and oversold occurrences.

RSI is calculated using the formula below to create an oscillator moving between 0 and 100, where RS = x-day average ‘near / x-day average’ near:

RSI = 100 – 100 / (1 + RS)

The RSI gradient reflects the speed of a change in the trend, while the directional movement reflects the size of the price movement in the underlying asset.

Having understood the requirements to derive the RSI, let’s see how this indicator is interpreted when analyzing the market.

Overbought and Oversold levels

The most basic application of RSI is to identify areas that are potentially overbought or oversold. Movements above 70 are interpreted as indicators of overbought conditions; conversely, movements under 30 reflect oversold conditions. The 50 level represents neutral market momentum and corresponds to the centerline in other oscillators such as the MACD.

The RSI that moves above the horizontal reference level 30 is seen as a bullish run indicator, while the RSI that moves below the horizontal reference level 70 is a bearish indicator.

As with other momentum oscillators, the overbought and oversold readings for RSI work best when prices are moving in a range rather than trending up or down.

Price/Oscillator Divergence

Wilder suggests that the divergence between an asset’s price movement and the RSI oscillator may indicate a possible reversal. The reasoning is that in these cases, the directional momentum does not confirm the price.

Bullish divergence forms when the currency or commodity falls further and the RSI falls further. RSI differs from bearish price action in that it shows consolidation momentum, indicating a possible upside reversal soon.

While a bearish divergence is formed when the underlying asset rises higher and the RSI forms a lower level. The RSI diverges from the bullish price action in the sense that it shows a weakening moment, indicating a possible downward reversal soon to occur.

As with overbought and oversold RSI levels, divergences could possibly give false signals during a strong trend.

Fault Changes

Wilder describes another important indicator of a possible price reversal called fault swings. A bullish failure swing occurs when the RSI moves below 30, rises above 30, and retraces again but remains above the 30 levels. The failure hit is complete when the RSI breaks its recent high; This breakout is interpreted as a bullish signal.

A bearish failure strike occurs when the RSI moves above 70, retreats below 70, and rises again but remains below 70. The failure strike is complete when the RSI breaks its recent low; This breakout is interpreted as a bearish signal.

The RSI is a more trustworthy indicator in a ranging market and is misleading in a trending market; however, a modified interpretation of RSI can be used in a trending market. For example, the RSI could move only between the 40 and 80 levels during a strong uptrend. In such a case, the RSI falling to 40 may indicate a potential bullish reversal area (resumption of the uptrend), and the level 80 can be seen as an overbought zone where it is not safe to enter long positions. On the contrary, in the context of a strong downtrend, the RSI can oscillate between 60 and 20. In this case,

RSI Trendline Breakouts

Trend lines can be used with the RSI oscillator itself, the same way they are used on price charts, connecting higher lows in an uptrend or lower highs in a downtrend. Breakouts that occur above or below these points can serve to indicate a potential reversal in price.

Despite being developed decades ago, the Relative Strength Index is still relevant today, despite the fact that traders now have access to a wide range of sophisticated technical trading tools. To avoid misleading signals, the RSI is best used to know whether the market is trending or varying. RSI can provide essential clues indicating potential trend reversals and compliment other indicators as part of a broader trading strategy.

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