Relative Strength Indicator
The relative strength indicator is an oscillating type of indicator that attempts to quantify price momentum. It's a front weighted, price velocity, ratio indicator developed by J.Welles Wilder in 1978. It should not be confused with other relative strength indicators that measure the strength of a single stock or commodity against the broader market. Instead this indicator measures the recent strength of a commodity relative to its past strength.
RSI = 100 - [100 / (1 + RS)]
RS = the ratio of the exponentially smoothed moving average of n-period gains divided by the absolute value of the exponentially smoothed moving average of n-period losses.
A simple expression of RS = Average price change for up days / Average price change for down days.
The indicator is bounded by the values 0-100 and can be used as an overbought / oversold indicator. The market is said to be overbought when the indicator is above the 70-80 line and oversold when below the 20-30 region. Different charting packages will use different parameters to determine the overbought / oversold lines, but these lines will always fall within the bands 20-30 and 70-80. The buy or sell trigger is activated when price reaches these lines, on a closing basis. A sell signal is activated when the indicator exceeds the overbought line and a buy signal is generated when the indicator hits the oversold line.
Divergence in the RSI indicator with respect to price will often indicate that a turn in price is imminent. Similarly failure swings, like in the example below, provide an indication that the market may be ready to turn. This occurs when the market makes a new peak, in this case a low, but the indicator fails to make a new peak low.
The latest signal generated, a sell signal, comes almost as the result of true divergence. Firstly, the indicator has just recently reached the 70 line indicating the market is near a top. A sell signal is generated when price eclipses that first high again, but the indicator fails to reach the same level as before.
© The MacLean Group Pty Ltd ACN 096 967 038. All rights reserved 2003. This article has been prepared by The MacLean Group and licensed to ASX. The views are those of the author and not of ASX. This material is educational and it is not intended to constitute financial advice.