Understanding the Relative Strength Index

The Relative Strength Index (RSI) is a technical analysis indicator that measures the speed and change of price movements. By measuring the magnitude of price changes, the indicator can evaluate both overbought and oversold market conditions.

Relative Strength Index is a versatile technical analysis tool for:

• Generating buy and sell signals
• Signalling overbought and oversold conditions
• Confirming price movements
• Signalling potential price reversals through divergences

The RSI momentum indicator appears in charts as a line graph oscillating between two extremes of 0 and 100. Whenever the momentum oscillator rises past the 70 level, technical analysts interpret that as overbought conditions from which a trend reversal may occur. Conversely, whenever the indicator plunges below the 30 mark, that is interpreted as an oversold condition from which price might reverse and start powering higher.

Likewise, technical analysts also maintain a close watch on the centerline while using the Relative Strength Index indicator for crossover opportunities. Whenever the indicator rises from below to above the 50 level, that is usually interpreted as a rising trend with regards to the price of the underlying asset. As the indicator approaches the 70 line, that signals increasing strength in the uptrend.

Similarly, a movement from above the centerline to below the 50 line signals a falling trend. When the indicator continue to move towards the 30 line, that indicates a bearish signal.

Whenever the price of the underlying security is in an uptrend, the RSI indicator will most of the time remain in the 40 to 90 range, as 40-50 act as support levels to help the price bounce back. In a downtrend, the indicator will range between 10 and 60, with 50 and 60 lines acting as a resistance level that could lead to the stock heading lower.

I. RSI Divergence

The Relative Strength Index can also be used to detect divergence in price action analysis. Whenever a stock’s price makes a new high or low that is not necessarily confirmed by the RSI, that’s interpreted as divergence, signalling a potential price reversal.

Whenever the Relative Strength Indicator makes a lower high followed by a downside move below the previous low, then a Top Swing Failure has occurred, signalling that the price may continue to move lower.

II. Using RSI

RSI is an ideal technical analysis indicator for identifying potential tops and bottoms in a market, thus helping to determine overbought and oversold market conditions. In addition, the indicator is also useful in confirming trend formations.

Whenever an uptrend is developing with regards to the price of an underlying security, the indicator will most of the time rise above the 50 centerline and trend upwards. Likewise, if a downtrend is developing, then the indicator will cross the 50 centerline from above and trend lower, in line with the decreasing price of the underlying security.

III. Bottom Line

Relative Strength Index has stood the test of time as a reliable indicator for identifying trends and price reversals as well as overbought and oversold market conditions. While oversold and overbought conditions are usually ripe for reversals, traders should also be aware that the same could signal a sign of strength.

Similarly, as bearish and bullish divergence produces sell-and-buy signals, technical analysts should always be careful in strong trends. RSI should always be used in conjunction with other indicators as a way of making an accurate decision for opening and exiting trades.