The relative strength index (RSI) is one of the principal momentum indicators used when analyzing charts. This article will focus in more detail on the RSI and how it's used to determine entry and exits.
Relative Strength Index
Determining the true value of an oscillator depends on the understanding of overbought or oversold positions. There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the RSI, which indicates to the investor whether an issue's price action is created by those overbuying or overselling it. The formula for the RSI is as follows:
|RSI = 100 -||100|
|1 + RS|
|RS = Average of x days\' up closes / Average of x days down closes|
At the bottom of the chart below, the RSI, on a scale of 0-100, indicates that the overbought position is at 70 and the oversold position is at 30. An investor may choose to reset the indicators' parameters to 80 and 20. This helps the investor be sure when making the decision to buy or sell an issue, and not "pull the trigger" too fast.
Reading the Chart
In the chart below, you can see that there is a distinct buy signal at the end of March 2001 as the indicator moves strongly above the 30 level. Here the price action continues on a strong climb from about the $25 level to above the $30 level. Then, the RSI moves with conviction into the danger zone, hitting 70+ on the scale six weeks later. Just before the end of June, the reverse occurs as the RSI moves downward through the 70 mark, indicating a strong sell signal.
Some traders have found that the RSI works best when it's compared to short-term moving-average (MA) crossovers. Using a 10-day MA with a 25-day MA, you may find that the crossovers indicating a shift in direction will occur very close to the times when the RSI is either in the 30/70 or 20/80 range; the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI, sooner than almost anything else, indicates an upcoming reversal of a trend, either up or down. (For related reading, see Momentum And The Relative Strength Index.)
"Failure swings" may help investors take the maximum advantage of the information provided by the RSI. The 30/70 on our scale represents the oversold/overbought positions. It is important to understand that an overbought or oversold position can remain in an extended uptrend or downtrend for some time. Traders should watch the volume indicators in the instances when the RSI has an extended showing either at the 30 or 70 level. This helps the investor determine if the interest in the issue is waning, and whether traders are now starting to take profits at the top end or starting to accumulate at the bottom end. Prior to using this tool to determine his or her own buy and sell entry points, a new investor should study old charts to see the kinds of price action that occurs at the top and bottom ends of the RSI scale. (For more insight, see Relative Strength Index And Its Failure - Swing Points.)
This should give you a basic understanding of the RSI and how it applies to the field of overbought/oversold positions. This very important indicator gives professional traders the signals for making the right decisions on both sides of the market. (For further reading, check out Buy High And Sell Low With Relative Strength and Value Investing + Relative Strengh = Higher Returns.)