Using the Relative Strength Indicator

Developed by J. Welles Wilder, The relative strength indicator is a very useful type of momentum study tool, measuring up and down days in an attempt to determine whether something is overbought or oversold. Oscillating between 0 and 100, a reading of below 30 is considered oversold and a reading of over 70 is considered overbought. The reading of overbought or oversold works best in a sideways moving price action. RSI can also be used to identify divergences, trends, failure swings and centerline crosses. Although a good indicator for reversals in the overbought/oversold readings, it is important that these readings can also be a sign of strength. Bearish divergences produce sell signals, but you have to be careful that it is not a false sign from that of a strong trend.

The RSI is calculated using the following formula: RSI= 100-100/(1+ RS) where RS is average amount of x days' up closes (average gains) divided by average amount of x days' down closes (average losses). A smoothing characteristic is given to the RS which makes it more accurate as more time periods are added to the study. As an example, here are the calculations involved in determining the RSI with a period of 14 days.

First Average Gain = Sum of Gains over the past 14 periods / 14
First Average Loss = Sum of Losses over the past 14 periods / 14

The next equations are based on the prior averages and current gain/loss

Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
Average Loss = [(previous Average Loss) x 13 + current Loss] / 14

This smoothing characteristic, as stated previously, makes the measurement more precise as more periods are added to the calculations. A preferred minimum for data points is to have at least 250.

Divergence between the price action and that of the RSI is a signal of a change in direction as directional momentum doesn't confirm price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum. Divergences, however, can be misleading in a strong trend and can show numerous divergences that amount to nothing more than a short-term pullback.

Failure swings happen within the RSI chart and are independent of price action.

Andrew Cardwell developed positive and negative reversals of the RSI. Although differing in view from Wilder, they are equally as useful in determining possible signs of reversal. A positive reversal forms when the RSI makes a new low and the price action makes a higher low, not at oversold levels but usually in between 30 and 50. A negative reversal is when RSI forms a higher high but price action makes a lower high.

Positive and negative reversals put price action before the indicator, which is the way it should be. Bullish and bearish divergences place the indicator before the price action, which isn't as reliable