Relative Strength Index (RSI) is an extremely useful and popular momentum oscillator. The RSI compares the magnitude of a stock’s recent gains to the magnitude of its recent losses and turns that information into a number that ranges from 0 to 100. It takes a single parameter, the number of time periods to use in the calculation. In his book, Wilder recommends using 14 periods.
The RSI’s full name is actually rather unfortunate as it is easily confused with other forms of Relative Strength analysis such as John Murphy’s “Relative Strength” charts and IBD’s “Relative Strength” rankings. Most other kinds of “Relative Strength” stuff involve using more than one stock in the calculation. Like most true indicators, the RSI only needs one stock to be computed. In order to avoid confusion, many people avoid using the RSI’s full name and just call it “the RSI.”
Use in stock market:
1. Overbought/Oversold
Wilder recommended using 70 and 30 and overbought and oversold levels respectively. Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal. Some traders identify the long-term trend and then use extreme readings for entry points. If the long-term trend is bullish, then oversold readings could mark potential entry points.
2. Divergence
Buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and the underlying stock. For example, consider a falling stock whose RSI rises from a low point of (for example) 15 back up to say, 55. Because of how the RSI is constructed, the underlying stock will often reverse its direction soon after such a divergence. As in that example, divergences that occur after an overbought or oversold reading usually provide more reliable signals.
