Relative Strength Index (RSI)
Introduction
Developed by J. Welles Wilder, the Relative
Strength Index (RSI) is a momentum oscillator that measures the speed and
change of price movements. RSI oscillates between zero and 100. According to
Wilder, RSI is considered overbought when above 70 and oversold when below 30.
Signals can also be generated by looking for divergences, failure swings and
centerline crossovers. RSI can also be used to identify the general trend.
RSI is an extremely popular momentum indicator
that has been featured in a number of articles, interviews and books over the
years. In particular, Constance Brown's book, Technical Analysis for the
Trading Professional, features the concept of bull market and bear market
ranges for RSI. Andrew Cardwell, Brown's RSI mentor, introduced positive and
negative reversals for RSI and, additionally, turned the notion of divergence,
literally and figuratively, on its head.
Wilder features RSI in his 1978 book, New
Concepts in Technical Trading Systems. This book also includes the Parabolic
SAR, Average True Range and the Directional Movement Concept (ADX). Despite
being developed before the computer age, Wilder's indicators have stood the
test of time and remain extremely popular.
Conclusion
RSI is a versatile momentum oscillator that has
stood the test of time. Despite changes in volatility and the markets over the
years, RSI remains as relevant now as it was in Wilder's days. While Wilder's
original interpretations are useful to understanding the indicator, the work of
Brown and Cardwell takes RSI interpretation to a new level. Adjusting to this
level takes some rethinking on the part of the traditionally schooled
chartists. Wilder considers overbought conditions ripe for a reversal, but
overbought can also be a sign of strength. Bearish divergences still produce
some good sell signals, but chartists must be careful in strong trends when
bearish divergences are actually normal. Even though the concept of positive
and negative reversals may seem to undermine Wilder's interpretation, the logic
makes sense and Wilder would hardly dismiss the value of putting more emphasis
on price action. Positive and negative reversals put price action of the
underlying security first and the indicator second, which is the way it should
be. Bearish and bullish divergences place the indicator first and price action
second. By putting more emphasis on price action, the concept of positive and
negative reversals challenges our thinking towards momentum oscillators.