A technical indicator developed by Welles Wilder to help investors gauge the current strength of a security price relative to its past performance. The RSI is an excellent overbought/oversold indicator that can be used to predict trend reversal points. Do not confuse this index with relative strength in its everyday definition as used in comparing the movement of one security, index or group against the movement of another security, index or group. Developed by J. Welles Wilder, Jr. and first described in his book "New Concepts in Technical Trading Systems", this is a momentum oscillator that measures the velocity of directional price movement.
It compares a security highest highs and lowest lows over a period of time. RSI is based upon the difference between the average of the closing price on up days vs. the average closing price on the down days.
U = average of upward price closes (EMA of gains)
D = average of downward price closes (EMA of losses)
The ratio between up and down closing averages is in fact the makeup of the index. The time period specified determines the volatility of the RSI. For example, a 9-day time period will be more volatile than a 21-day time span. The author (Wilder) uses an n value of 14 days but other values may be used that better fit particular securities. The 9-day and 25-day RSIs have also gained popularity. Because you can vary the number of time periods in the RSI calculation, I suggest that you experiment to find the period that works best for you.
The RSI is a price-following oscillator that ranges between 0 and 100. A popular method of analyzing the RSI is to look for a divergence in which the market index is making a new high, but the RSI is failing to surpass its previous high. This divergence would be an indication of an impending reversal. When the RSI then turns down and falls below its most recent trough, it is said to have completed a failure swing. The failure swing would be considered a confirmation of an impending reversal.
In Mr. Wilder's book, he discusses five uses of the RSI in analyzing commodity charts (these apply to indices as well):
1. Tops and Bottoms: RSI readings above 70 indicate the shares are overbought and are likely to start falling. Readings below 30 indicate the shares are oversold and a rally can be expected. (AmiBroker automatically draws horizontal lines at these levels). The RSI usually forms these tops and bottoms before the underlying price chart.
2. Chart Formations: The RSI often forms chart patterns (such as head and shoulders or rising wedges) that may or may not be visible on the price chart.
3. Failure Swings: This is where the RSI surpasses a previous high (peak) or falls below a recent low (trough).
4. Support and Resistance: The RSI shows, sometimes more clearly than the price chart, levels of support and resistance.
5. Divergence: As discussed above, this occurs when the price makes a new high (or low) that is not confirmed by a new RSI high (or low).