Overbought Or Oversold? Use The Relative Strength Index To Find Out

By Dan Blystone AAA
The Relative Strength Index (RSI) was created by J. Welles Wilder Jr. and introduced in his book, "New Concepts in Technical Trading Systems," published in 1978. Wilder was a mechanical engineer and real estate investor before going into market research and trading. He spent most of his life in Greensboro, N.C., before moving to New Zealand.
 
RSI is one of several popular technical indicators developed by Wilder, including Parabolic SARAverage True Range (ATR) and the Average Directional Movement Index (ADX). Still widely used, these classic indicators are often included by default in charting and technical analysis software.
 
RSI is not to be confused with relative strength, which compares a security's performance to that of an overall market average or index such as the Dow Jones Industrial Average.
 
RSI Basics
 
The Relative Strength Index is one of a group of technical indicators known as momentum oscillators. Other well-known momentum oscillators are the Moving Average Convergence Divergence (MACD) and the Stochastic Oscillator.
 
RSI measures the velocity and magnitude of directional price moves and represents the data graphically by oscillating between 0 and 100. The indicator is calculated using the average gains and losses of an asset over a specified time period. The default look-back 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. Raising the setting decreases sensitivity, causing fewer instances of overbought and oversold conditions.
 
RSI is calculated using the following formula to create an oscillator that moves between 0 and 100, where RS = average of x days' up close/average of x days' down close:
 
RSI = 100 - 100 / (1+RS) 
 
The RSI gradient reflects the velocity of a change in the trend. The directional movement in the RSI reflects the size of the price move in the underlying asset. 
 
Now that we know the basic components used in generating the RSI, let's look at how this indicator is interpreted in analyzing the market.
 
Overbought and Oversold Levels
 
The most basic RSI application is to use it to identify areas that are potentially overbought or oversold. Movements above 70 are interpreted as indicating overbought conditions; conversely, movements under 30 reflect oversold conditions. The level of 50 represents neutral market momentum and corresponds with the center line in other oscillators such as MACD.
 
In terms of market analysis and trading signals, RSI moving above the horizontal 30 reference level is viewed as a bullish indicator, while the RSI moving below the horizontal 70 reference level is seen to be a bearish indicator.
 
As with other momentum oscillators, overbought and oversold readings for RSI work best when prices are moving within a sideways range rather than trending up or down. 
 
forex screen grab
Figure 1: The elipse marks RSI movement into overbought conditions above 70 on the EUR/USD chart.
 
Price/Oscillator Divergence
 
Wilder suggests that divergence between an asset's price movement and the RSI oscillator can signal a potential reversal. The reasoning is that in these instances, directional momentum does not confirm price.
 
A bullish divergence forms when the underlying asset makes a lower low and RSI makes a higher low. RSI diverges from the bearish price action in that it shows strengthening momentum, indicating a potential upward reversal in price.
 
A bearish divergence forms when the underlying asset makes a higher high and RSI forms a lower high. RSI diverges from the bullish price action in that it shows weakening momentum, indicating a potential downward reversal in price.
 
As with overbought and oversold levels, divergences are more likely to give false signals in the context of a strong trend.
 
RSI illustration
Figure 2: Bearish Price/Oscillator Divergence on the USD/JPY chart. Price makes higher highs, while RSI makes lower highs, indicating a potential bearish reversal.
 
Failure Swings
 
Wilder outlines another important indicator of a potential price reversal called failure swings. A bullish failure swing forms when RSI moves below 30, rises back above 30 and pulls back again, but holds above the 30 level. The failure swing is complete when the RSI breaks its recent high; this breakout is interpreted as a bullish signal.
 
A bearish failure swing forms when RSI moves above 70, pulls back below 70 and rises again, but holds below 70. The failure swing is complete when RSI breaks its recent low; this breakout is interpreted as a bearish signal.
 
RSI illustration
Figure 3: Bearish Failure Swing. In this instance RSI moves above 70 into overbought territory. It then moves back below 70, reverses upward but remains below 70. RSI then falls again and breaks out below the prior low, in this case the 62.52 level marked in red, generating a bearish signal.
 
RSI in Trending Vs. Ranging Markets
 
As mentioned in the above interpretations of RSI, it is a more reliable indicator in a ranging market and can give misleading signals in a trending market; however, a modified interpretation of RSI can be used in a trending market. For example, during a strong uptrend, RSI might move only between the levels of 40 and 80. In such a case, RSI falling to 40 can signal a potentially bullish reversal area (resumption of the uptrend) and the 80 level can be viewed as an overbought area where it is not safe to initiate long positions. Conversely, in the context of a strong downtrend, RSI might range between 60 and 20. In this case, the 60 level may be viewed as a potential area for a bearish reversal (resumption of the downtrend) and the 20 level as an area reflecting oversold conditions.
 
RSI Trend Line Breaks
 
Trend lines can be used on the RSI oscillator itself, in the same way as on price charts, by connecting higher lows in an uptrend or lower highs in a downtrend. Breakouts above or below these trend lines can serve to indicate a potential reversal in price.
 
RSI/forex illustration
Figure 4: An RSI trend line break in EUR/USD, signaling a potential bullish reversal in price.
 
The Bottom Line
 
Despite being developed over 30 years ago, RSI remains relevant today even though traders now have access to a vast array of sophisticated technical trading tools. To avoid misleading signals, the RSI is best used with an awareness of whether the market is trending or ranging. RSI can give important clues indicating potential trend reversals and can serve to compliment other indicators as part of a broader trading strategy.
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